The problem is rooted in the tax code provision that treats debt that is cancelled as if it were income.
While debt cancelled in a bankruptcy case is an exception to the rule, homeowners who lost their homes and had debt cancelled as a result were exposed to the inclusion in their gross income of money they never saw.
The bill that has protected homeowners outside of bankruptcy for the past four years was set to sunset December 31.
The extension will protect homeowners in certain circumstances from cancellation of debt income. Become familiar with the requirements.
And check your state tax codes to see if state tax law mirrors the federal law.
This federal tax provision is not the answer to all problems at the intersection of tax and foreclosure.
Remember that the safe harbor doesn’t cover refinances or second homes and rental property.
If a property that doesn’t qualify for the exception is foreclosed before a bankruptcy is filed, the tax consequence is not mitigated by the later filing of bankruptcy. (The insolvency exception may help, but note that it includes retirement assets in the balance sheet test.)
Further, foreclosure is a sale for the purposes of capital gains taxes. Since the capital gain is measured by comparing the tax basis with the sale price (not the sale proceeds), those who suffer foreclosure may still have a capital gains tax to deal with.
Image courtesy of RyanLerch.