The Mortgage Forgiveness Debt Relief Act of 2007 was suppose to prevent homeowners who experienced foreclosure from receiving a huge tax bill on forgiven debt caused by the foreclosure. But to many homeowners' surprise the law doesn't protect all homeowners who have lost their property to foreclosure. Under the Mortgage Forgiveness Debt Relief Act, the tax liability incurred from the foreclosure will be waived only if the debt was accrued from buying or improving the property.
Sounds simple enough, right? Not so fast. Remember all of those home equity loans and refinances that required homeowners to roll their credit card debt into their mortgage? Well, that is taxable. So if you refinanced your $100,000 home for $140,000 and rolled $20,000 of credit card debt into the refinance, after your home is foreclosed on you will still owe taxes on that $20,000. For those homeowners who have suffered from foreclosure, paying any type of tax is a huge blow, especially on a home they no longer own. The only way that a foreclosed homeowner can avoid this tax liability is to file for bankruptcy.
But the law states that the taxpayer must be insolvent at the time of the foreclosure or the foreclosure must occur after or during the bankruptcy in order to have the tax waived. That means if a debtor has retirement funds or any other assets at the time of the bankruptcy, they might still be stuck with the tax debt caused by the foreclosure.