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Foreclosure Tax Consequences

Bank Foreclosure sales can result in severe tax consequences! If you lose your home and it's sold for a profit, you could owe taxes on that profit!

Bank Foreclosure can save or cost you taxes!

Your tax liability depends on whether you have a recourse or non-recourse loan. Recourse means you, the borrower, has personal liability for the loan, in addition to the risk of losing your real property.

The Tax Consequences of Non-Recourse Loans

Non-recourse loans include bank loans and seller carry backs and typically include loans used to buy an owner occupied residence of up to 4 units.

Most States protect borrowers from personal tax liability for a mortgage on a home in which they occupy at the time of purchase and, if they convert the home to a rental unit they are still protected. The reason behind this is to place the risk on the lender so the most they can do is take back the house.

The law applies to properties of up to 4 units, and only to loans used to purchase the property. In some cases you are protected when you refinances if you do not receive any cash upon closing or you use the cash for property repairs or improvements

Special rules may apply to VA and FHA loans.

The tax consequences of foreclosure, deed in lieu of foreclosure, or short sale (See FAQ) on a non-recourse loan are simple: the property is taxed as if it were sold for the total outstanding amount of the loan (or sales price, if higher). Taxability of the gain and deductibility of the loss depend on the nature of the property.

Foreclosure Tax Analysis Examples:

Example 1

Linda owes $150,000 on a property she bought for $190,000, now worth $130,000. If the house is foreclosed, the lender accepts a short sale or Linda gives the property back to the bank, she is taxed as if she had sold the property for $150,000.

Her loss of $40,000 is not deductible if it's her residence, but deductible if the property is a rental. If you expect a loss on your own home, move out, rent the property, and then you may be able to deduct the loss since the property is a rental!

Example 2

Tom owes $150,000 on a property he bought for $140,000, now worth $110,000. If the house is foreclosed, the lender accepts a short sale or Tom gives the property back to the bank, he is taxed as if he had sold the property for $150,000.

His $10,000 profit is subject to the "sale of residence" rules; (2 year roll-over & Over-55 Rule apply), or rental property rules, depending on his use of the property.

Example 3

Sally owes $200,000 on a property she bought for $190,000. At the foreclosure auction, it sells for $210,000. She is taxed as if she had sold the property for $210,000.

Please keep in mind that the examples are over-simplified and the basis for determining gain or loss is not the cost of property. Instead, initial cost is reduced by depreciation and profit rolled over from prior sales, increased by capital expenditures, and affected by other tax rules. Also, in a Deed in Lieu of Foreclosure, the sales price includes past due interest, but the IRS allows an offsetting interest deduction.

The Tax Consequences of Recourse Loans

Under the recourse loan, the borrower is personally liable if the property is sold for less than the amount owed to the lender. Two issues of concern are personal liability and taxation.

Personal liability

To obtain a personal judgment against you, the lender must proceed with a Judicial Foreclosure. However, if the loan was recourse and the lender proceeds with a Trustee's Sale, you are relieved from personal liability for any remaining deficiency and the lender cannot collect under a Trustee's Sale.

Profit: Tax Liability

There are two elements of profit: `true profit,' and relief from debt income. `True profit' is computed as if the property were sold for its value; relief from debt income is taxable if the debt exceeds the property's value.

A foreclosure, Deed in Lieu, or a short sale (involving recourse debt) are taxed identically.

If the debt is $200,000 and the property's value is $180,000, the owner's `true profit' is taxed as if he had sold the property for $180,000; relief from debt income is taxable on the $20,000 debt in excess of the property's value.

If the owner's "cost basis" is less than the value, he has a taxable `true profit.'

"Cost basis" is determined by examining the property's initial cost, plus capital improvements, less any deferred profit from prior tax deferred sales (from the 2 year roll-over of a primary residence or for investment property). If the property cost $250,000 and profit of $100,000 was rolled over from prior sales into this home, its cost basis is $150,000.]

`True profit' is taxed as if from a regular sale of the property and may qualify for a tax deferred sale of a primary residence (if you plan on buying a new home within 2 years), and for the Over-55 Rule.

The other kind of taxable income is `relief from debt income,' based on the difference between what is owed and the value of the property, $20,000 ($200,000 debt, less $180,000 value).

The 2 year roll-over and the Over-55 Rules do not apply to relief from debt profit.

Relief from debt income is taxable only to the extent that the debt relief results in solvency. If the owner has a negative net wealth before and after the sale, nothing is taxable. Alternatively, if he has negative net worth before, and $3,000 net worth after, up to $3,000 is taxable.

If the owner is in bankruptcy, no relief from debt income is taxable.

These rules are complicated and point out that in any circumstance in which unexpected tax results are possible, a thorough examination by an experienced tax professional must be sought before it's too late!