Foreclosures have been increasing on all types of properties, from vacation homes to commercial sites. Nonetheless, the boom in foreclosures is probably being felt mostly by homeowners.
The prospect of losing your home can be stressful. You may be trying to figure out a way to catch up on the mortgage to avoid foreclosure. If it's too late, you may be trying to find a new place to live. It's easy to overlook the tax consequences for home foreclosures. These consequences may come as an unpleasant surprise.
A tax bill from the Internal Revenue Service (IRS) may be sent to you after the foreclosure is finished. Whether you receive a bill depends on a variety of factors:
Recourse or Non-Recourse
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.
On the other hand, if your mortgage is non-recourse, your lender can't make you pay the loan. The only thing it can do is foreclose and sell your house for payment on the debt.
Regardless of whether your mortgage is recourse or non-recourse, the foreclosure is a taxable sale for you. This is true even if you give the lender a deed to your home in satisfaction of the debt, which is called a deed or transfer "in lieu of foreclosure." Since the foreclosure is treated as a sale, you have to report any gain from the sale as income. You'll be taxed on that gain.
Unfortunately the reverse isn't true. You don't get a deduction for any loss that you might have as a result from the foreclosure.
Figuring a Gain
To figure your gain from the foreclosure, take the difference between the amount realized from the sale and the adjusted tax basis of the home. Usually, your adjusted tax basis equals the price you paid for the home plus the cost of major improvements. The amount realized generally equals the gross proceeds minus expenses. In a foreclosure, the amount realized depends a lot on whether your loan is recourse or non-recourse:
- Recourse loans - if your home is sold at a foreclosure sale, the amount realized is its fair market value (generally the sales price) minus expenses of the sale (court costs, legal fees and real estate commissions)
- Non-recourse loans - the amount realized equals the amount you owe on the mortgage plus any interest that comes due up to the time of the foreclosure
Cancellation of Debt
Generally, if you borrow money from banks or credit card companies, and the lender cancels or forgives that debt, the amount of debt that's cancelled is income for federal tax purposes. The cancelled debt is "money in your pocket" because you don't have to repay it.
Until recently, the same logic applied to most recourse mortgages. After surviving the stress of foreclosure, many people were surprised by a tax bill from the IRS. For example, say at the time of foreclosure you still owe $200,000 on your mortgage. According to the bank's appraisal, the fair market value of the home is only $190,000. If you transfer the house to your bank in lieu of foreclosure, and the bank doesn't make you pay the $10,000 difference, or "deficiency," then you have a $10,000 taxable gain.
There are some exceptions. For instance, debts that have been discharged through bankruptcy aren't considered taxable income. Similarly, if you're insolvent (your total debts are more than the fair market value of your total assets) when the debt is cancelled, some or all of the cancelled debt usually isn't taxable.
In the case of non-recourse mortgages, there's no cancelled or forgiven debt. With these mortgages, the amount realized on foreclosure (or transfer in lieu of foreclosure) is never less than the outstanding debt. In other words, the price the property sells for at foreclosure is treated as the balance owed on the loan, no matter what the sale price may be.
The Mortgage Forgiveness Debt Relief Act (MFDRA)
Late in 2007, spurred by soaring home foreclosures, the MFDRA became law. Generally, it lets you exclude from your taxable income most if not all of any cancelled or forgiven debt that might come about because of a foreclosure. There are limits, however:
- The cancelled debt has to be on your principal residence. The debt can be from a loan that you took out to buy, build or substantially improve your home. It can also be for refinancing the mortgage on your home. Since it applies only to your principal residence, commercial and vacation properties usually don't qualify.
- Only debt that's forgiven in 2007 through 2012 qualifies.
- If you file a joint tax return with your spouse, you can exclude up to $2 million of forgiven debt from your income. If you're married and file separately, you can exclude up to $1 million.
- You have to report the amount of forgiven debt on a special IRS form, and attach it to your tax return.
If your forgiven debt doesn't qualify under the MFDRA, don't forget about the insolvency and bankruptcy exceptions noted above.
Questions for Your Attorney
- If given a choice, should I choose a recourse or non-recourse mortgage?
- If I bid on my house at the foreclosure sale and win, can I still take advantage of the MFDRA?
- I'm trying my best to pay my mortgage on time, but it's getting harder each month. Do you think I should stop paying my mortgage and force the bank to foreclose?
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