When you start paying off your mortgage, the difference between the original amount you owed and your current balance is called your equity, or the portion of the home that you own outright. If your financial circumstances change and you have to sell the home at a loss, you will lose the equity in the home. This loss has tax consequences as well as financial consequences.
If you sell your home for more than you paid for it, the IRS considers the excess to be a capital gain, even if you haven't paid off your mortgages against the home. Thus, you have to pay capital gains tax on the sale of the home even if you gave the profit to your mortgage lender. However, if your gain was less than $250,000 ($500,000 if you are married and filing a joint tax return) you can exclude it from your income.
No Deduction for Loss
If you sell your home at a loss -- that is, for less than you paid for it -- you can't deduct the loss from your taxes. Selling residential property at a loss is considered a non-deductible personal loss. If you sell an investment property at a loss, you can claim the loss as a deduction off of your taxes.
If your mortgage lender forgives part or all of your debt or you lose your home through foreclosure, you must pay taxes on the portion of your debt that was forgiven. Your mortgage lender will send you a 1099C form at the end of the year listing the amount of debt that you had forgiven. As of the time of publication, you can exclude up to $2 million of debt on principal residences from forgiven debt.
If you file for bankruptcy, your mortgage debt, including forgiven debt and capital gains, is usually discharged. Thus, you won't have to pay taxes on the debt after your bankruptcy goes through. Bankruptcy has a negative effect on your credit for seven to ten years after you file; check with a financial adviser or bankruptcy attorney to make sure this is your best option.
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