However, like with most things there are exceptions. First, let’s start with the most pressing subject area, which are foreclosures. Congress wisely enacted the Mortgage Forgiveness Debt Relief Act (hereinafter “Mortgage Act”). This act generally allows taxpayers to walk away from their principal residence without any tax implications on any deficiencies.

The Mortgage Act applies to forgiven debt in the calendar years 2007 through 2012. Up to $2 million of forgiven debt is eligible under the Mortgage Act (if you file separately, $1 million). The debt must be related to your principal residence, therefore, any rental or business properties will not qualify under the Mortgage Act.
So, let’s say you owe $200,000.00 on your principal home. You default and end up getting foreclosed on. At the foreclosure sell the bank only receives $120,000.00. After the bank adds all their legal fees and costs, the total deficiency on the home is $100,000.00. The bank decides to forgive the debt and sends you a 1099-C. At this point, if you do nothing, the $100,000.00 will be treated as income and will be taxable. This could create a $30,000.00 tax obligation to the IRS!
Now, let’s say the above happens in 2012. The individual debtor, let’s call him John, would qualify under the Mortgage Act because:

* The home was his principal residence
* The debt was forgiven by the mortgage company
* The debt is below the $1/$2 million limit.

So, in order for John to avoid paying taxes on the foreclosure deficiency, he needs to attach the Form 982 to his IRS Tax Return. On the Form 982, John needs to complete lines 1e and 2 and make sure the form is attached to his normal tax return. See FORM 982. That’s it, John can now rest easy.

Now, since we are getting close to the deadline let me give you one other fact scenario. Let’s assume that your home is foreclosed in 2013 and that the debt is forgiven sometime in 2013. Also, let us assume that Congress in their abundant wisdom decides not to renew the Mortgage Act. Well, now we have some serious concerns. If the Mortgage Act is not renewed then any forgiven or cancelled debt on a foreclosure will constitute income for your tax return purposes. This means you will owe the IRS very significant amounts of money.
Now, before you allow the fear to take control, there is an exception. Let’s go back to the wonderful form 982. There is also an INSOLVENCY EXCLUSION. If you qualify, then those forgiven debts will not constitute income.

How do you know if you are Insolvent?

It’s actually quite simple. You are insolvent when your total liabilities exceed your total assets. Assets include everything you own, e.g., vehicles, houses, furniture, life insurance, stocks, pensions, 401ks, etc. See Insolvency Worksheet. The insolvency exclusion applies to not only foreclosures but also nonbusiness credit cards.
The key is whether you were insolvent immediately prior to the cancellation/forgiveness of the debt. If you were, then you will get to use the magic form 982.
Now, the IRS requires you to do a little more work when claiming the insolvency exclusion. Now, because my direction could be construed as giving tax advice, I would suggest you consult a tax professional to help you fill out the form 982 properly. Now, if you want to give it a go on your own the IRS has a great publication that will help you. See Publication 4681.