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Tax Consequences of Foreclosure

May 18, 2009

If you’ve lost your home through foreclosure there are potential tax consequences that you may have over-looked.

There are two possible consequences you should consider:

1. Taxable cancellation of debt income

2. A reportable gain from the disposition of the home

Cancellation of Debt

If your lender cancels or forgives the debt you borrowed, depending on your specific circumstances, you may have to include the canceled amount on your income taxes. Since you were obliged to repay the financial institution, you were not required to include the mortgage proceeds in income. The amount you receive, when that obligation is subsequently forgiven, generally means you must report it as income, since you are no longer required to repay the lender. The lender will likely send you a Form 1099-C, Cancellation of Debt showing the total canceled debt.

For example: You borrow $175,000 and default on the mortgage loan after making payments totaling $25,000. If the lender is unable to collect the remaining balance of the debt from you, a cancellation of debt of $150,000 is created, which is generally taxable income to you.

Capital Gain

Despite a foreclosure, you may have still realized a gain during your possession of the property. If this occurs you will need to calculate the profits from the foreclosure by subtracting the amount realized from the sale from the adjusted tax basis of the home. The cost of improvements to the property in addition to the original price of the property is your adjusted tax basis. Your gross proceeds minus your expenses will be your gain. In a foreclosure the amount realized depends a lot on whether your loan is recourse or non-recourse:

For recourse loans, if your home is sold at a foreclosure sale, the amount realized is its fair market value, which is generally the sales price, minus expenses of the sale, such as court costs, legal fees and real estate commissions. If your mortgage is a recourse loan, you're personally responsible for repaying the bank or mortgage company. If you don't repay the loan, or "default," the bank can sue you for the remaining amount due on your loan if the proceeds from a foreclosure sale doesn't cover the amount you owe.
For non-recourse loans, your amount realized equals the amount you owed on the mortgage plus any interest that comes due up to the time of the foreclosure. if your mortgage is non-recourse, your lender cannot make you pay the loan. The only thing it can do is foreclose and sell your house for payment on the debt.

Gratefully there are other situations when cancellation of debt may not be taxable:

If you have declared bankruptcy the discharged debt is considered non-taxable.
If your total debts are more than the fair market value of your total assets, you are consider to be insolvent and may qualify for an exemption.
If you run a farm and the debt was incurred in the operation of it, you may also qualify for an exemption.

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Tax Consequences of Foreclosure

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