Do You Have to Pay Taxes on a Deed in Lieu?

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A deed in lieu of foreclosure could be a tax liability.
A deed in lieu of foreclosure could be a tax liability. (Image: Jupiterimages/Comstock/Getty Images)

A deed in lieu of foreclosure, often referred to as a voluntary or friendly foreclosure, is when a homeowner who has fallen behind on mortgage payments signs the deed of his home to a bank or lender to avoid a foreclosure. If you are considering a deed in lieu of foreclosure, you might fear the tax consequences of this transaction could put you further in the financial hole. Unfortunately, there is no one answer when it comes to determining whether you will have to pay taxes on a deed in lieu.

Role of “Deficiency Amount”

Uncle Sam considers the difference, if there is one, between how much you owe on your mortgage and the present value of your property, as a deficiency amount. This amount in the past was taxed as if it were actual income, even though you would not have received a penny from the lender.

Legislation Affecting Tax Liability

The Mortgage Forgiveness Debt Relief Act of 2007 provides that homeowners do not have to pay federal taxes through 2012 under certain circumstances. These include if the deed in lieu is an individual’s primary residence, if the loan you are filing a deed in lieu of was used to buy, build or improve your primary residence or if the mortgage is secured by a home used as a primary residence. Thus, in such cases, you do not have to worry about a tax liability although the deficiency amount must still be reported to the Internal Revenue Service (IRS). If you don’t fall under these exceptions, you face a federal tax liability for the deficiency amount. As of Spring, 2011, it was not clear whether legislators intended to extend the act’s provisions beyond 2012.

Other Ways to Avoid Liability

Uncle Sam also allows you to avoid any tax liability when doing a deed in lieu of foreclosure if at the time of the deed in lieu you are insolvent, meaning that your debt load is greater than your total assets. If you filed for bankruptcy before closing on your home, you are also not liable for any taxes as the result of a deficiency amount.

Some Tax Liability Unavoidable

Just because you end up with zero federal tax liability on a deed in lieu of foreclosure doesn’t mean you’re completely off the hook. You may have to pay state income taxes on the deficiency amount. Different states have different laws for taxing deficiency amounts in a deed in lieu of foreclosure. For instance, California law provides forgiveness of tax liability for deeds in lieu just from 2007 through 2009. Additionally, you do not owe property taxes starting from the date the deed is transferred to the lender. However, any property taxes incurred before that time remain your responsibility.

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