I was in Las Vegas recently and was asked several times (mostly on the radio) about taxes and home foreclosures. Southern Nevada is unfortunately still mired in the effects of a tough housing market — arguably more so than out here in Southern California. Still, I thought I'd offer some details on the subject from the federal tax side of things.
Depending on facts and circumstances, if a home is foreclosed or sold and the lender also forgives some or all of the mortgage debt, there may be tax consequences. One is dealing with a potential gain on the disposition of the home, and the other is cancellation-of-debt income.
Foreclosures are generally treated like sales for tax purposes. (Note that some or all of the gain from the sale of a personal residence may qualify for exclusion from income. More on that topic can be found online.
Cancellation or debt forgiveness usually results in taxable ordinary income. However, under the Mortgage Debt Tax Relief Act of 2007, taxpayers can exclude up to $2 million ($1 million for married filing separate) of qualified debt forgiven on their principal residence. To qualify, the debt must have been used to buy, build or substantially improve your principal residence and be secured by that residence. The special exclusion applies to debt forgiven during tax years 2007 to 2012 through foreclosure, mortgage restructuring and short sales.
Debt forgiven on second homes, rental property, business property, credit cards or car loans does not qualify for the new tax-relief provision. There are several exceptions and exclusions that could allow part or all of debt cancellation income to be treated as nontaxable. Those include debt cancellations that are intended as a gift, cancellations through bankruptcy, or when a person is insolvent.
More resources: (Publication 4681 is excellent)