HELOC Default May Result in Tax Bill After Foreclosure

A couple bought a new home in Tucson with a first mortgage loan four years ago. The real estate market was still booming at that time, and by the time they moved into the home there was an additional $40,000 in appreciation. They took out a $40,000 Home Equity Line of Credit (“HELOC”). This $40,000 was used to buy a new car and to pay off their credit cards. Unfortunately, the home is now “under water” by potentially $80,000 and they can no longer afford to make the mortgage payments on the first mortgage loan. According to Arizona real estate law, if they stop making the mortgage payments both on the first mortgage loan and on the $40,000 HELOC, when will the foreclosure occur? Will their wages be garnished? Would they be responsible for any income taxes if the first mortgage loan or the $40,000 HELOC do not get full payment of their loans?

If the first mortgage loan forecloses, they generally would not have liability for any deficiency. Until the time of the actual foreclosure sale (which you should personally attend), however, they will have to keep the home in reasonably good condition, which means they also must keep up their homeowner’s insurance policy. The $40,000 HELOC will not foreclose, but will get a judgment against them for $40,000, and can garnish your wages and take other collection action. In regard to income taxes, they will have no liability for income taxes on the potential $80,000 debt forgiveness because there is no income tax on debt forgiveness of a mortgage loan used to purchase a primary residence, or to make improvements such as landscaping or a new roof to a primary residence. Inasmuch as the HELOC was not used to purchase or make improvements to a primary residence, if the HELOC lender gets less than $40,000, they should owe income tax on the difference between the amount paid by them and the full $40,000 owed.

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