Income Omission Penalty

• If you fail to disclose the income that results from the foreclosure of your home, the IRS is likely to impose an accuracy-related penalty. Since the foreclosure may increase your taxable income for the year, the IRS can increase the amount of tax you owe on the undisclosed income by 20 percent if it's a "substantial understatement." A substantial understatement of tax occurs when the foreclosure income omission represents 10 percent or more of the correct amount of tax you owe or $5,000, whichever is larger.
  
  

Foreclosure of Home

• Not every foreclosure will result in taxable income or gain. If your mortgage is a non-recourse loan, then you will never incur taxable ordinary income on the debt your lender cancels after a foreclosure. A non-recourse loan is a mortgage that states you are not responsible for the mortgage balance if the sale proceeds are insufficient to cover the entire outstanding balance of the mortgage. However, if the terms of your loan are recourse, meaning that you are unconditionally responsible for repaying the full mortgage balance, then any debt the lender cancels may result in income that you must report to the IRS.
  
  

Excluding Ordinary Income

• When your lender forecloses on a home and the terms of your mortgage state that it's a recourse loan, you need to calculate whether you have additional taxable ordinary income to report to the IRS. Your ordinary income will equal the mortgage balance immediately before the foreclosure less the fair market value of the home on the date of foreclosure. However, in most cases, the bank will send you a Form 1098 to report the value of the home if it decides to forgive or cancel your obligation to satisfy the mortgage balance. If you receive this form, you can avoid the underpayment penalty by reporting the canceled debt on your tax return; otherwise, the IRS can increase the amount of tax you owe on this income by 20 percent if an omission is a substantial understatement.
  
  

Excluding Capital Gains

• Even if you don't have any debt cancellation that results in ordinary income, you may still have an obligation to pay capital gains taxes on the foreclosure since the IRS treats the transaction as if you are selling the home. For recourse loans, you calculate the gain as the value of the home minus your tax basis in the home. But if your loan is non-recourse, then you substitute the outstanding balance of your mortgage after the foreclosure for the fair market value in the gain calculation.