As we all know by watching the news, the real estate market is pulling back hard from the days of glory earlier this decade. In fact, many people are losing their homes to foreclosure. Few realize the tax consequences of losing one's home.

The Internal Revenue Service looks at things in a strange manner. What you may see as a loss, it sees as a gain. How could this possibly be? Well, the agency takes the view that any loss that relieves you of a financial obligation is actually a monetary gain. Let’s look at an example.

Assume I own a house. I am carrying a $200,000 mortgage on the home. I run into problems making the payments and the home goes into foreclosure. I eventually am evicted and the bank takes back the home. I have lost the house and my credit is a disaster, but I am off the hook for the $200,000. Life could be worse, right? Well, it is about to get much worse.

The IRS is very interested in that $200,000 mortgage debt. The agency takes the view that the relief from that debt can actually be considered income to me. Yes, the IRS views the foreclosure as though I have received a $200,000 salary for the year. You can guess what comes next. The agency wants me to pay taxes on it!

As foreclosures go up around the nation, more and more people are getting very surprising letters from the IRS. It isn’t bad enough that you have lost your home, you now have a monstrous tax bill. This also applies to situations where a short sale is undertaken.

So, is there anything you can do? Yes. The key is to get an appraisal of the home before you are foreclosed on. This forces the lender to value the home at an objective price, not some low figure it arbitrarily sets. This is important as you are taxed on the difference between the value of the home and what you owe.

In addition to the appraisal, you can make arguments to the IRS. There are different approaches, but the basic idea is to suggest you received no gain and are insolvent. The IRS can then waive the tax liability.

If all else fails, there is always the bankruptcy route. Although taxes generally are not terminated through bankruptcy, the “gain” you are perceived to have received is. Since there is no gain, there can be no tax and you are off the hook. Of course, this approach shreds whatever small amount of positive credit you had left, but it beats a big tax bill.

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