Many times in foreclosures, people who have fallen behind on their payments walk away from their home without considering all the future consequences. One recurrent consequence is the possibility of tax liability arising from cancellation of all or a portion of the debt previously secured by their home. The liability can accrue via a foreclosure, short-sale, deed-in-lieu of foreclosure or even a loan modification.
For instance, when a home is sold at foreclosure for $25,000 less than what is owed on it, that $25,000 difference is cancelled by the lender and is reported to the IRS. The IRS in turn views the “cancellation of debt” as income you received because you are no longer liable to repay the cancelled debt. This amount is then taxed at regular income tax rates.
Cancelled debt income does not always result in tax liability. For example, under the Mortgage Debt Relief Act, certain homeowners are not required to pay taxes on forgiven debt. There are a number of criteria for this to apply, so you should consult with a CPA to see if this applies to you. You can also check for other exceptions directly with the IRS. In particular, you may want to look at Publication 4681.