Recourse or Nonrecourse

Recourse mortgages require you to make additional payments to the lender in the event that a home's fair market value is less than the outstanding loan balance. If, after the foreclosure, the lender forgives the additional loan balance due, the IRS includes the forgiven amount in taxable income for the year. If you have a nonrecourse mortgage, you are not responsible for the outstanding loan balance after a foreclosure. Debt forgiveness on a nonrecourse loan does not require you to report additional amounts of taxable income.

Gain or Loss

The calculation of gain or loss on the foreclosure of a home is similar to the calculation of a voluntary sale. The gross proceeds of the foreclosure on a home with a nonrecourse mortgage is equal to the outstanding loan amount. For a recourse mortgage, the gross proceeds are equal to the lesser of the home's fair market value or the outstanding loan balance that you are not personally liable for. As with any home sale, you will subtract the home's tax basis from your gross proceeds to arrive at the taxable gain or loss. The home's tax basis is the amount you actually paid to buy the home plus any permanent improvements you made prior to the foreclosure.

Character

If you owned your home for more than one year before the foreclosure, then any resulting gain or loss will be treated as a long-term capital gain or loss for tax purposes. Capital losses can offset an unlimited amount of capital gains you report in a tax year. If capital losses exceed gains, you can deduct up to $3,000 of the loss from ordinary taxable income each year. You can carry forward the excess loss indefinitely until you are able to use it. You must report the transaction on the Schedule D attachment to IRS Form 1040.

Income Tax Reporting

The mortgage lender will send you a Form 1098-C that reports the amount of debt subject to cancellation as a result of the foreclosure of a home. This is the amount you must include in ordinary taxable income on a personal tax return and does not affect the amount you must include in the gross proceeds on the foreclosure of the home. If the forgiven debt is less than $600, the lender will not provide you with Form 1098-C. However, this does not relieve you of the obligation to report forgiven debt amounts on the tax return.

Qualified Principal Residence

If the foreclosure results in the cancellation of mortgage debt you used to purchase, construct or improve the main home, the gain may be excludible from taxable income. A main home is any residence that you use as the principal residence and ordinarily live at during the year. The maximum debt cancellation you can exclude on a qualified principal residence is $2 million. If you are eligible for this exclusion, you must report the transaction on Form 982 and attach it to the relevant tax return.