The Effects of a Deed in Lieu on Your Taxes

A "deed in lieu of foreclosure" is a way out from under a mortgage that you can't afford. Turn the deed over to your mortgage lender and walk away debt-free, in theory. Homeowners can still end up owing the lender for the remaining debt, however. In other situations, an owner may find that the IRS regards the unpaid debt as a form of income, subject to taxes.

You can't get the full benefits of a deed in lieu by dropping the deed on your lender's desk and walking away. In many states, your lender can still sue you if it can't sell the house for enough to pay off your mortgage debt. In return for giving up the house without a fight, you need an agreement that your lender won't file a deficiency lawsuit. You may have to try selling your house first; if that doesn't work, your lender may agree to accept the deed rather than go to the cost of foreclosure.

You didn't pay income tax on your original mortgage because it's a loan, not income. If you don't pay part of it back, the government considers the unpaid debt income, and therefore taxable. Under the Mortgage Debt Relief Act of 2007, you do not have to pay any tax on forgiven mortgage debt on your personal home, provided you gave the lender the deed in lieu between 2007 and the end of 2012. If, however, the forgiven debt is greater than $1 million or $2 million -- depending on your filing status -- you pay tax on the amount above the cutoff point.

Even if your debt forgiveness is covered by the act, you still have to report the forgiven debt on your tax return. Your lender should send you a 1099-C form stating the amount of the forgiven debt. You then report that on form 982; if that's the only item you report on the form, you'll only need to fill out a couple of lines. You also use the form, which you attach to your 1040, when you report taxable forgiven debt.

If you sell your home to avoid foreclosure using a "short sale" and your lender accepts the price in payment of your debt, the same tax rules apply as with a deed in lieu. If you use Chapter 7 bankruptcy to wipe out your mortgage debt, there's no tax obligation; your lender however, can still foreclose by using the mortgage lien attached to your property, the Nolo legal website states. In states that don't allow for deficiency judgments -- so your lender can't do more than take your house -- the IRS assumes that a deed in lieu or short sale settles the debt, so there's nothing to tax.

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