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What are the Tax Consequences of Foreclosure?

Posted on Mon, Apr 22, 2013

The answer depends on the circumstances. The two most important variables in determining the federal income tax consequences of a principal residence foreclosure are:
1. Is the mortgage recourse or non-recourse?
2. What is the value of the property in comparison to the mortgage balance?

describe the imageHere are the various scenarios that may apply.

Recourse Mortgage: Property Worth Less than Loan Balance

When the property's fair market value (FMV) is less than the recourse mortgage balance (the most common situation in foreclosure situations), the tax rules treat the foreclosure as a sale of the property for the FMV amount. So the foreclosure triggers a tax gain if the FMV of the home exceeds its basis (basis usually equals the purchase price plus the cost of improvements).

However the gain will often be free from federal income taxes thanks to the principal residence gain exclusion break. Under the exclusion, unmarried homeowners can exclude (pay no tax on) gains of up to $250,000. Married joint-filing couples can exclude gains of up to $500,000.

To qualify for the exclusion, you generally must have:

  • Owned the home for at least two years during the five-year period ending on the foreclosure date; and
  • Used the home as your principal residence for at least two years during that five-year period.
    If the basis of a principal residence exceeds FMV, the foreclosure transaction will trigger a nondeductible loss.

If the lender then forgives part of all of the deficiency (the difference between the recourse mortgage debt and the foreclosure sales proceeds), the forgiven amount constitutes cancellation of debt (COD) income for tax purposes. Any COD income must be reported as income on your Form 1040 for the year the debt forgiveness occurs, unless you qualify for a tax-law exception.

Recourse Mortgage: Property Worth More Than Loan Balance

When the property's FMV exceeds the recourse loan balance (a less-common situation), the foreclosure is treated for federal income tax purposes as a sale of the property for a price equal to the loan balance plus any additional proceeds received by the borrower from the foreclosure sale.

Summary of Recourse Loans

The single most important factor to understand about a recourse mortgage foreclosure is that the lender can come after a borrower for any deficiency that remains after the foreclosure sale. It can take many months or even several years for a lender to decide whether to pursue a borrower for the full deficiency, forgive part of it, or forgive the whole thing.

Tax-wise, the most important factor to understand is that a principal residence recourse mortgage foreclosure can result in a gain and maybe some COD income too. Thankfully, any gain will often be free from federal income taxes thanks to the principal residence gain exclusion break. (State tax results may vary.) Some or all of any COD income may also be tax free thanks to beneficial tax-law exceptions described in the right-hand box. When no exception applies, COD income must be reported as income on a borrower's tax return for the year the debt forgiveness occurs.

Non-Recourse Mortgage

A foreclosure by a non-recourse lender is treated for federal income tax purposes as a sale of the property to the lender for an amount equal to the non-recourse mortgage balance. The property's FMV is irrelevant, and the lender cannot pursue the borrower for any deficiency. There's never any debt forgiveness, because the taking of the property in foreclosure is deemed to completely satisfy the nonrecourse loan. Therefore, there is no possibility of taxable cancellation of debt (COD) income with a non-recourse mortgage foreclosure.

However, there will be a gain or loss from the deemed sale to the lender.

A gain occurs if the non-recourse loan balance exceeds the property's basis (usually the original purchase price plus the cost of any improvements). The gain will often be federal-income-tax-free thanks to the principal residence gain exclusion break. It allows an unmarried person to exclude (pay no tax on) a principal residence gain of up to $250,000 or $500,000 for a married couple filing jointly). To qualify, you generally must have owned the home for at least two years during the five-year period ending on the foreclosure date and used the home as your principal residence for at least two years during that five-year period.

If the property's basis exceeds the non-recourse loan balance, the foreclosure triggers a non-deductible loss.

Summary of Non-Recourse Loans

With a non-recourse mortgage, the single most important factor to understand is that the lender cannot come after a borrower for any deficiency after the foreclosure sale. Tax-wise, the most important factor to understand is that a principal residence non-recourse mortgage foreclosure can result in a gain. Thankfully, the gain will often be free from federal income taxes thanks to the principal residence gain exclusion break. (State income tax rules may be different).

As you can see, the tax consequences of a foreclosure are complex. If you have questions about your situation, click here to contact one of EHTC's tax advisors.

Tags: Michigan State and Local Tax (SALT), business consulting, Federal Income Tax, EHTC, Taxes, Consequences for Foreclosure, Foreclosure