There are a lot of factors surrounding each situation of foreclosure. These factors determine the tax consequences. The most important factor to consider when trying to figure out the federal income tax consequences of a foreclosure on a principal residence is:
What is the value of the property and how does that value compare what is owed on the mortgage?
Again, there are a variety of factors that can determine tax consequences on a foreclosure, but these following scenarios are the most common.
Loan Balance is Higher than Property Value
A property’s fair market value can be less than the mortgage balance owed to the lender. This is the most common scenario in a foreclosure. Tax rules take into consideration that the sale of the property is at the fair market value. However, it is essential to know that this foreclosure scenario could result in a tax gain if the fair market value of the home is more than the cost basis, which is the purchase price plus the cost of any improvements.
When the fair market value is higher than this cost basis, the gain can be free from federal income taxes. This is a result of the exclusion that the property is your principal residence. Under this rule, homeowners who are not married can exclude a gain or profit of up to $250,000. Those homeowners who are married can exclude gains of up to $500,000. What this means: homeowners will not have to pay capital gains taxes up to these dollar amounts.
For this tax exclusion to apply, homeowners will have to certify that they:
- Owned the home for at least two years or more during the last five-year period ending on the foreclosure date.
- The home was the principal residence for the individual or couple for at least two years or more during that five-year period.
When the cost basis of a foreclosure is greater than the fair market value, a nondeductible loss will occur.
The lender can forgive part of or all of the deficiency owed the them. The deficiency is the amount between the sales proceeds and what the lender is actually owed. If this amount is forgiven, then it is considered a cancellation of debt which must be reported on the homeowner’s Form 1040 in the year the debt was forgiven.
Loan Balance is Less than the Property Value
If the property in question has a higher fair market value than what is owed on the loan, the home is considered for federal income tax purposes, a sale of the property for a price equal to the loan balance and adds any additional proceeds that the homeowner received. In this scenario, the cost basis is the same as the previous scenario discussed. This situation is a lot less common then the first.
Recourse Loans: Important Factor
A lender has a right to go after a homeowner for any deficiency or shortage that remains after a foreclosure sale is completed. The debt still remains after a foreclosure. The lender can pursue the homeowner for that amount still owed to them. It can take quite some time for a lender to decide if they want to forgive the debt, pursue for the deficiency or even forgive the debt partially. So, it is essential to keep this factor in mind when sorting through your foreclosure.
The important things to take away from all of this is that a residential mortgage foreclosure can leave you with some capital gains and some cancellation of debt income as well. Fortunately, if you lived in the home as your principal residence and your gain follows the guidelines mentioned above, you can be excluded under this rule. There are also tax law exceptions in which some or even all of the cancellation of debt income may be tax exempt. However, when there is no exception that can apply, the cancellation of debt income has to be reported as income within the year the debt cancellation or forgiveness occurred.
Remember, each state can vary as well, so be sure to do your research and contact a professional for any assistance to insure you end up at the best possible scenario.