Foreclosures and your income tax
estimated sale
When you lose your home to foreclosure, or the property is returned to the lender (deed-in-lieu of foreclosure), a presumed sale or exchange has taken place under Section §1001(a) of the Internal Revenue Code. This sale or exchange of property could result in a tax gain or loss, and the recognition of income for cancellation of debt (COD) to the taxpayer. The cancellation of the debt will result in taxable income for the taxpayer unless there is an exception within the statute (IRC Section 108) that is beyond the scope of this article. An important factor that will determine the treatment for tax purposes is whether your loan is recourse or non-recourse.
Tax treatment of your foreclosure
When an asset is sold, the difference between the realized amount and the taxpayer’s “adjusted basis” on the asset will determine the amount of recognized gain or loss. The Realized Amount will be the property’s fair market value (FMV) or the face value of the debt, depending on whether the debt is classified as recourse or non-recourse. Consequently, if the debt is non-recourse, the amount realized will be the face value of the debt, creating more profit, but not canceling the income on the debt. In contrast, if the debt is resorted to, a lower gain is recognized, because the fair market value of the property at the date of sale is used instead, but there is the possibility of having to recognize COD income. This COD income will be the difference between the face value of the debt and the FMV of the property.
Know Your State Laws Consumer Laws
The tax treatment of foreclosure on your home will depend on whether your mortgage loan was a recourse or non-recourse loan. Some states have laws that prevent banks from going after homeowners for unpaid loan balances for primary residences, creating a non-recourse situation.
Loan with recourse:
1 – The amount realized is the FMV of the Property.
2- The adjusted basis is what you paid for the property or acquisition cost, plus capital improvements.
If the property was a rental, then you must subtract depreciation from the adjusted basis.
3- The cancellation of the debt income is the difference between the fair market value and the nominal value of the debt.
4 – Gain or loss is the difference between the fair market value and the adjusted basis.
5 – Attribute reduction and/or elimination of deductible losses due to any income exclusion of forgiven debt under IRC Section 108, due to cancellation of debt, must also be calculated, which is outside the scope of this article .
Non-recourse loan
1 – The amount realized is the nominal value of the debt.
2 – The adjusted basis is what you paid for the property or the acquisition cost as in (2) above.
3 – Cancellation of debt income is not a problem with recourse debt.
4 – The gain or loss is the difference between the face value of the debt and the adjusted basis.