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This depends on the nature of the forclosure and what the home eventually sells for.
In theory, if the FMV of the home, which is generally determined to be the sale price of the home, is less than the mortgage loan, the bank forgives the loan. Forgiven debt is normall reported on schedule C and is considered taxable income.
it is also possible, if your home was refinanced, that you could also incur a capital gain. Capital gains exposes you to capital gains tax. However, in a majority of instances, the rules for taking the capital gain exclusion , would be applied, and you would end up paying no capital gains tax.
In addition, under the new Mortgage Relief Act, you are entitle to attempt to relieve any tax debt created by a forclosure by completing the following form.
This form essentially reduces attributes so that you can elimiante in part or in whole, all forgiven debt to the extent of insolvency so that you do not pay taxes as a result.
the debt bill was actually passed; it is called the .The Mortgage Forgiveness Debt Relief Act of 2007
The form that I linked you to was modified last month by the IRS to allow homeowners to comply with the act.
So where line 1 e is for principle residnece, you may include other debt that is not a priciple residence on anothe line. Read the instructions carefully for other debt that is non-business debt. They give an example of a car, but those items listed are examples and not inclusive. Use it for the second home.
Additionally, if any of the debt for the second home was used to "improve or extend the value of the primary residence, that portion of the debt goes on line 1 e.
You can have a degree of insolvency which caused a lien to be forclosed on. You can avoid paying taxes on forgiveness of debt to the degree of insovency. So it is possible to still have some insolvency and still retain your home at the time of the forclosure on the second home.
When i stated that you could avoid capital gains tax, it was assuming you had a forclosrue on the primary residence. Your initial question that i respondided to did not contain this bomb.....so i gave a response on primary residence, and suddenly it is your second home and now my answer has to change slightly.
You are entitled to a maximum capital gains exclusion if you both owned the home and lived in it as your primary residence for at least 2 of the past five years. The time spent in the home does not have to be continuous. So you can add up say, 1/4 yaers or half years over the course of 5 years to total 2 years, in order meet the maximum capital gains exclusion from taxes. That maximum exclusion is 250,000 of capital gain if filing a seperate or single return, and 500,000 if filing a joint return. If you lived in the home as your primary residence (yes even the second home) less than the 2 years and was required to sell it because of unforseen circumstances you can take a porportional reduced capital gains exculsion form taxes.
Unforseen circumstances are: