Lender Leniency

• Some homeowners leave hundreds of thousands of dollars in debt on their mortgages following foreclosure. The news that your debt has been forgiven, even partially, can feel like a relief. However, if you do not meet certain criteria, you may owe the IRS instead.
  
  

IRS: Friend or Foe?

• When your lender provides a debt cancellation, the company writes off the debt canceled to you on Form 1099-C, Cancellation of Debt. The lender's reduced tax liability is often offset by the homeowner's increased tax burden. IRS tax code states that your mortgage loan is considered a liability, and untaxable, as long as you are responsible for paying back the loan. However, when the lender decides to get rid of the debt, you are often taxed as if the canceled debt is income.
  
  

Exclusions

• If you are insolvent, your liabilities are greater than the fair market value of your assets. Homeowners who are insolvent at the time of foreclosure are considered to be excluded from taxation on canceled debt. "For purposes of determining insolvency, assets include the value of everything you own (including assets that serve as collateral for debt and exempt assets which are beyond the reach of your creditors under the law)," explains the IRS. Also, if you are bankrupt or incurred certain farm debts, you may also be excluded.
  
  

Debt Swap: Lender vs IRS

• Homeowners whose lenders did not fully cancel their debt may end up owing both the IRS and the mortgage company after foreclosure. Insolvency can help mitigate your financial burden in both cases. "Lenders or collection agencies may wait until debtors have recovered financially before they swoop in," explains Les Christie of CNN Money. The complexity of insolvency and tax liabilities can be great. Consult with a tax professional to determine the best way to calculate the extent to which you were insolvent immediately before your debt was canceled.