Home foreclosures are still a major problem around the country with foreclosure starts jumping nearly 20% from July through August according to a report by Lender Processing Services. If losing a home is not one of the worst things that can happen, to add insult to injury, a taxpayer may owe Federal and/or State taxes as a result of the foreclosure. For the sake of this article, the focus will be on Federal taxes, and there are two possible tax consequences that need to be considered:
1) A reportable capital gain on the sale of property – Under Federal tax law, the IRS likens a foreclosure or the disposition of a home as a sale
2) Cancellation of debt income or income for debt being forgiven– Generally, when a taxpayer receives a loan, they do not have to pay taxes on it because it must be paid back. However, when debt is forgiven or canceled, that amount needs to be reported as income.
Let’s look at both of these Federal tax implications in the event of a foreclosure.
Calculating the Capital Gain or Loss With a Foreclosure
Determining a capital gain or loss in a foreclosure or repossession is calculated in a similar fashion as with a gain or loss from a sale or exchange. To calculate the loss or gain from a foreclosure we must first calculate the adjusted cost basis of the property (normally the purchase price plus the cost of major improvements) and then subtract it from the amount realized from the sale. But what is the amount realized? Well, to figure that out we must first determine whether the loan is classified as recourse or non-recourse debt.
Recourse Loan vs. Non-Recourse Debt
As a broad definition here, recourse debt or a recourse loan means the lender can pursue legal action for the amount of money still owed by the debtor after collateral is transferred (in this case the home). Contrastingly, a non-recourse loan or non-recourse debt means the lender can only repossess the property and sell it but generally cannot take further legal action if the collateral fails to satisfy the total debt owed. State laws, the type of loan (purchase or refinance) and what the note actually says determines the classification.
If the loan is classified as a recourse loan, the amount realized would be the lower of either the property’s fair market value or the amount of outstanding debt before the foreclosure lowered by any amount the debtor is personally liable for after the foreclosure. If the loan is a non-recourse loan, the amount realized would be simply the debt amount remaining right before the foreclosure (including any interest). Normally, when a bank acquires an interest in a property from foreclosure, Form 1099-A will be sent to out to the taxpayer/debtor. This form will have the information needed to calculate any gain or loss.
Do I Owe Taxes If There is a Gain With the Foreclosure?
Not necessarily. If the home was your primary residence for at least 2 out of the last 5 years terminating on the day of the foreclosure, up to $250k ($500k for married filing jointly) may be excluded from income and you would not have to pay taxes on it. If it was not your primary residence, or the gain was greater than $250k, report this number on Schedule D. If the foreclosure was a rental property, report it on Form 4797. If you calculate a loss, unfortunately, you cannot take a deduction for this amount.
Cancellation of Debt Income or Forgiven Debt Income
In addition to being possibly taxed on a realized gain from a foreclosure, you could face taxes on canceled or forgiven debt (normally reported to you on form 1099-C) because in a sense you received tax-free income. This would be reported on Form 1040, Line 21. Non-recourse loans don’t create “cancellation of debt income.” However, with a recourse loan, you could have taxable income from the cancellation of debt.
Any Exceptions With Owing Taxes on Forgiven Debt With Recourse Loans?
Even with a recourse loan, you may still not accumulate tax debt on forgiven debt due to some of these legal exceptions:
- Legislation – Any amount forgiven up to $2 million ($1 million if married filing separately) by the bank/lender is not taxable through 2012. Why? The Mortgage Forgiveness Debt Relief Act of 2007 extended this exclusion through 2009, and then the Emergency Economic Stabilization Act of 2009 extended it through 2012.
- Insolvency – If your debts exceed the fair market value of your assets when your debt is forgiven/ canceled, all or part of the forgiven debt may not cause tax liabilities.
- Bankruptcy – Debts canceled or discharged in bankruptcy are generally not taxable.
- Intended as a Gift – If the cancellation is intended as a gift, you may not have to report the cancellation of debt income
With the legislation exception discussed above, it would only be valid if:
- The property was your primary residence (not a vacation home)
- The debt was used to purchase, build, improve, or refinance a primary residence (cannot have used cash-out refinance loan or home equity loan to pay off credit card debt, purchase a car etc)
- You completed a short-sale, where the proceeds were less than what you owed the lender and the lender wrote it off
- IRS Form 982 is completed and attached to the taxpayer’s return
IRS Tax Worksheet to Calculate Forgiven Debt Income & Capital Gains
The worksheet below is derived from the IRS worksheet and serves only as a general guide to help taxpayers figure out any capital gain or canceled debt income that may result from a foreclosure. Since non-recourse loans do not generate cancellation of debt income, if you have a non-recourse loan, skip section 1 and proceed to section 2. In section 1, realize the Fair Market Value is determined on the date of the foreclosure sale.
Foreclosing on a home can be a tough experience for anyone to handle and having an understanding of the possible tax consequences that can result is always a plus. If you believe there is a discrepancy with any 1099-C or A, be sure to contact the bank or lender that issued it. It is always recommended that you work with a tax professional when dealing with a foreclosure simply because many state laws vary and filing the correct forms can be cumbersome. For more information see IRS Publication 4681.