Mortgage Interest Requirements

• Before evaluating the implications of your foreclosure, it’s beneficial to understand the requirements for claiming a deduction for mortgage interest. The tax law only allows the deduction for the mortgages you have on qualified homes and for which the lender takes a security interest. However, since your home is in foreclosure, it’s sufficient to conclude that your mortgage lender has a security interest since this interest is what allows it to foreclose on your home. Moreover, your qualified homes include your principal residence plus one additional home that you use for personal reasons.
  
  

Must Pay Interest

• For purposes of claiming the mortgage interest deduction, you must understand the distinction between the interest payments that accrue on your mortgage and the interest that you actually pay. The Internal Revenue Service only allows you to deduct the amount of interest you pay during the year, regardless of the amount you accrue. For example, if your annual mortgage payments in 2011 include $12,000 of interest charges but you only make payment for $3,000, the maximum mortgage interest deduction you can claim on your Schedule A is $3,000.
  
  

Deduction During Foreclosure

• When your mortgage lender decides to foreclose on your home to recover its investment, it’s almost always a result of not receiving your mortgage payments for many months. Therefore, you cannot claim a deduction for any mortgage interest payments you fail to pay during the year. For example, suppose during 2011 you pay the first two mortgage payments of the year but you don't make March through December payments; your lender decides to initiate foreclosure on your home. In this case, you can still claim a deduction for the mortgage interest you pay in January and February but not for the payments you miss for the remainder of the year.
  
  

Foreclosure Tax Implications

• If your lender is unable to obtain a price for your home that covers your outstanding mortgage balance, it may decide to forgive or cancel the remaining debt. The IRS treats the amount of a debt cancellation as gross income to the debtor. However, when the cancellation relates to a foreclosure on your principal residence, some exceptions apply, depending on the terms of the mortgage documents you sign at closing. Since calculating the taxable portion of a mortgage debt cancellation is complex, it’s best to consult with an accountant or attorney before including the debt in your gross income.