The Tax Consequences of Debt Forgiveness after Foreclosure and Short Sale

The IRS states that there is no debt forgiveness on non-recourse debt/loans. In Arizona, non-recourse debts are mortgages that were used to purchase and/or improve homes, also known in most cases as, “purchase money loans.” An example of non-recourse debt/loan is a first mortgage which purchased 100% of a home. Another example of a non-recourse debt/loan is both a first and a second mortgage where the first mortgage went towards a percentage of the home purchase, and the second mortgage went towards another percentage of the home purchase. Here, because the second mortgage went towards purchasing the home, it is a non-recourse debt/loan. An example of what a non-recourse debt is not, is a second mortgage where the homeowner took out cash and used it for something else (e.g. buying a car, boat, etc.). Most of these loans are know as “home equity lines of credit” or “HELOCs”.

The Mortgage Debt Relief Act of 2007, provides for no tax on short sale difference or foreclosure deficiency of non-recourse loans, if the home is a primary residence. So, for example, if the homeowner had a simple 80/20 mortgage where both went 100% towards purchasing the home, the homeowner will not be taxed after short sale or foreclosure. If, however, the homeowner had a “HELOC”, or some other non-recourse loan which was forgiven, they will be issued form 1099 and taxed for the forgiveness.

Debt forgiveness on “HELOCs” and other non-recourse debts are rare after foreclosure and short sale on most occasions. Almost always, after short sale/foreclosure, the homeowner must make arrangements with their lender to pay the HELOC (unless of course in the foreclosure sale, the HELOC is satisfied or paid off entirely). If the homeowner does not make arrangements, they face collection and/or civil action.

After foreclosures or short sales which involve “HELOCs” many homeowners consider options available to them under the bankruptcy code. Filing for bankruptcy protection after foreclosure/short sale can discharge a homeowner’s obligations to pay a HELOC. Many homeowners who “see the writing on the wall” are considering their options even before foreclosure/short sale, when they know they will be unable to pay the HELOC afterwards. Filing for bankruptcy protection even before foreclosure or short sale can work retroactively in protecting homeowners from their obligations under a HELOC. It is important to seek the advice of an experienced bankruptcy attorney to know your rights and obligations.