Tax Rules

• "If you are liable for a debt that is canceled, forgiven, or discharged, you must include the canceled amount in gross income," according to the Internal Revenue Service. In other words, if you don't repay a debt, it's taxable. If a rental property you own has been foreclosed upon, the way you may see it is that you have lost a lot of money. The way the IRS sees it, you were given a lot of money by the lender and, just like income, it's taxable.
  
  

Recourse or Not

• One of the key phrases in the IRS explanation is "if you are liable." With regard to mortgage liability, there are two classifications: recourse and nonrecourse. A recourse mortgage is one for which you are personally liable. If you default, the lender can not only foreclose on the property, they can come after you for any difference between the home's value and the balance you owe. A nonrecourse mortgage is one for which you are not personally liable. In this case, if you default, the lender can foreclose on the property but can't come after you for any difference between what you owe and the home value. State law often specifies whether a mortgage is recourse or nonrecourse. In just a few states, like Hawaii, all loans -- in Hawaii's case, all loans issued after July 1, 1999 -- are nonrecourse. In most states, all mortgages are considered recourse. In others, like California, some loans are recourse and others aren't.
  
  

Mortgage Forgiveness Debt Relief Act

• The hurricane of foreclosures sweeping many parts of the country post-2006 resulted in Congress considering the issue of whether people who have lost their property to foreclosure should have to pay tax on money they clearly don't have any more. They came up with a law -- the Mortgage Forgiveness Debt Relief Act of 2007 -- that lets homeowners out of the tax for foreclosures of their principal residences only. The exemption applies to both purchase and refinance loans; however, the exemption is limited to the amount of money required to purchase the house, so if you refinanced into a larger loan than the original loan, you will owe tax on the difference, if it was not repaid. There is also a cap of $2 million, for married couples, and $1 million for singles, on exempted loans.
  
  

Worse Than Tax

• If having to pay tax on unpaid debt is bad, not being let out of the debt may be worse. When you are personally liable for any difference between the home value and loan amount, the lender can file what is known as a deficiency judgment against you. If granted in court, this allows the lender to attach liens to your other assets and even garnish your wages. If your loan is recourse, the lender can file for a deficiency judgment.