Many individuals who fell on hard times may have struggled to pay their mortgage or spent hours negotiating their credit card debt with their lender. If these scenarios resulted in a foreclosure or cancelled balances, it's important that borrowers know how these actions will impact their tax bill so they can be prepared.

Cancelled debt is often treated as taxable income by the Internal Revenue Service. For example, if an individual carried a $15,000 credit card bill, and the lender agreed to forgive $8,000, the borrower may be taxed on the latter amount because it is classified as income for tax purposes. This can come as a shock to many Americans who are struggling to get their finances back in order. In some cases, those who receive a 1099-C notice regarding cancelled income from credit card debt may be exempt from paying taxes on a portion or full amount of those funds. By IRS standards, those whose liabilities exceeded their assets when the debt was settled were insolvent, which may mean they don't have to pay forgiven debt.

Foreclosure is another scenario that may result in a tax bill from Uncle Sam. However, this can be considerably more complicated than cancelled credit card debt, and those who lost their homes through this process should consult their tax preparer to discuss their liability.

The IRS treats foreclosures as the sale of property, meaning that owners may not only be required to pay capital gains on the "sale," but also income from cancelled debt, depending on whether they carried a recourse or non-recourse loan. Consumers who held a recourse loan are personally liable for the debt, and lenders may pursue repayment following the foreclosure. Those with non-recourse loans are not legally liable for their balances. Instead, lenders repossess the property to secure the loan.

To determine capital gains or losses, the basic formula involves subtracting the adjusted basis of the property - typically the purchase price plus any home improvements - from the fair market value of the property or, for non-recourse loans, the outstanding loan balance immediately prior to the foreclosure. If the calculation resulted in a gain, and borrowers used the home as their primary residence for at least two years during the five-year period ending on the date of foreclosure, they may qualify to exclude up to $250,000 from income. This amount increases to $500,000 for married couples filing jointly.

Lastly, those with non-recourse loans will not have cancelled debt income because lenders may not pursue repayment of the loan. However, those with recourse loans may find that they are liable for their balances, and should consult a tax professional following the sale to discuss their particular situations.

Every effort has been taken to provide the most accurate and honest analysis of the tax information provided in this blog. Please use your discretion before making any decisions based on the information provided. This blog is not intended to be a substitute for seeking professional tax advice based on your individual needs.