- While the general tax rule is that unpaid debt is taxed because it is considered income, there are some fine points that distinguish some types of mortgage debts from others. Mortgages are classified as either nonrecourse or recourse loans under state law. Each state has its own set of rules. A nonrecourse loan is a loan for which the lender has only one way, or recourse, to recover and this is through foreclosure. The lender cannot garnish your wages, sue you or even threaten to sue you. If you do not pay back a nonrecourse loan, it is not, therefore, considered an unpaid debt. It is not a personal debt at all. You therefore do not have to pay taxes on a nonrecourse loan that was not repaid. A recourse loan, on the other hand, is a personal debt. First the lender can foreclose on the property securing the debt and then can sue you for any difference between the value of the foreclosed house and what you owe them. If there is an unpaid debt on a recourse loan, you owe federal tax on it.
Temporary Federal Exemption
- For the tax years 2007 through 2012, you are exempt from paying tax on any unpaid recourse loan if that loan was secured by your principal residence and you lost the house through foreclosure, short sale or deed in lieu, which is a process in which you deed the house to the lender to avoid foreclosure.
Pay the Debt or Pay the Tax
- Between 2007 and 2012, then, the only type of unpaid mortgage debt you will have to pay taxes on is an unpaid recourse loan on an investment property or second home. Because it is a recourse loan, the lender may make you pay the debt by obtaining a deficiency judgment against you. If you pay, you will not have any tax liability. The lender may choose to forgive the loan, not out of the goodness of its heart but because the legal process to pursue the judgment is difficult or impossible for them to pursue. If that is the case, you will have to pay taxes on the unpaid debt.
What is the Tax Bill?
- The amount of debt on which you pay tax is the difference between the proceeds the lender receives after selling the house and the loan balance. The lender will send you a tax form with the exact figure, which you in turn must report on your tax return. This amount will be taxed at the same rate your ordinary income is taxed.