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The nightmare of bank foreclosure can surge into a sweeping, devastating climax, but beware! It can also rebound at the end of the tax year with additional repercussions.

With the sad combination of higher interest rates from loans that are readjusting, falling market values and tougher bank policies on lending, many property owners are caught in a whirlpool that drags them further and further into foreclosure. And while the negotiations and decision-making about "how" to handle the actual retaking of the property by the bank is critical to the process, it's also of extreme importance to understand and accept the tax consequences that will occur after the process is done.

Foreclosure means the property owner will lose the property, but this can happen in several ways, and these ways will determine the tax consequences of "cancellation of debt" income.

What is this "cancellation of debt" income? Simply put, a mortgage involves the bank's granting of funds to the property owner in return for a promise to pay the funds back. Since the property owner begins to repay the money, they don't claim the money as income on their tax return.

However, the picture changes when the property owner cannot or will not fulfill their promise to repay the money. Now, the bank's only recourse is to take the property back and somehow try to recoup their money. In the case of an auction, where the lender is the only bidder to buy back the property, the amount bid can be very low, resulting in a higher debt cancellation amount.

If the market value of the property has risen, or if the property cost basis was subject to depreciation for business purposes, it is possible for the property owner to lose the property, have debt-discharge income and have capital gain income upon the sale of the property.

This is where the tax consequences come in. The original loan was based on the value of the property, but property values change. If the property is now sold for less and the bank cannot recover all the money it lent, the balance is reported to the property owner and the IRS on a Form 1099-C, Cancellation of Debt. In most cases, this amount results in income which must be reported on the property owner's income tax form, and which will trigger capital gains and income tax for them.

There are some instances where this income is not taxable. For example, debts discharged through bankruptcy are not taxable. Insolvency of the property owner may qualify him for canceled debt tax, as can certain farm debts and non-recourse loans. These situations require the assistance of a tax professional to determine when they are applicable.

For ALL those facing foreclosure, its important to review all the facts ahead of time with both the lender and a good tax planner to see which taxes could be triggered by the event. Good preparation, experience and knowledge of the tax laws, along with the application of an individual's particular facts and circumstances, will make a world of difference when it comes to the tax consequences of foreclosure.

Learn more about this author, Linda Sorcie Smith.
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