Many of my clients have lost rental properties and homes to foreclosure. Unfortunately, foreclosures can create taxable income on top of losing your property.

Good News About HAMP: The IRS says that mortgage payment reductions under the government's HAMP program generally won't be taxed as income.

What Forms You'll Get

The bank should send you either Form 1099-A or Form 1099-C. (Sometimes banks that went out of business don't send any forms.) These forms show:

• What the bank thinks the property was worth when they took it

• How much you still owed on the mortgage

Important: Check these numbers with your tax accountant. Banks often guess too low on property values and sometimes incorrectly include extra interest in the mortgage balance.

Cancellation of Debt (COD) Income

When your mortgage balance is higher than the property's value, that difference is called "cancellation of debt" and is usually taxable income.

Special California Rule for Short Sales: Both the IRS and California now say that if you do a short sale on your main home in California (with the original mortgage), you won't owe personal income tax on the forgiven debt. This is because California law says you can't be held personally responsible for the shortfall on your original home loan. Instead, the forgiven amount gets added to your property sale calculation.

Good News for Rental Properties

Losing a rental property to foreclosure is treated like selling it, which can actually help you tax-wise:

• You can claim a loss equal to the property's value when the bank took it, minus what you originally paid, plus all the depreciation you claimed over the years

• Any unused rental losses from previous years become available to use in the foreclosure year

• These two benefits often reduce or eliminate the tax on cancelled debt, sometimes even creating an overall tax loss

The Insolvency Exception

You might not owe tax on cancelled debt if you were "insolvent" the day before the bank took your property. This means that your total debts exceeded your total assets. This exception works for both federal and California taxes.

Bottom Line

This covers the most common situations, but there are many other exceptions (including bankruptcy) and details not mentioned here. If you think foreclosure or a short sale is coming, talk with an experienced tax accountant right away to understand your options.