Unexpected and Unfavorable Tax Consequences on Foreclosures
A common misconception concerning properties in foreclosure is that the homeowner or investor being foreclosed upon will not suffer any tax ramifications. How could someone who is unable to make mortgage payments have taxable income after the lender forecloses on their property? Unfortunately, foreclosures are surprisingly common today as an aftermath of the recent housing meltdown, and adding insult to injury for the borrower undergoing the foreclosure, there are often unfavorable tax consequences that result from the process.
Prior to the real estate downturn in late 2008, many homeowners refinanced their homes to take advantage of historically low interest rates. This also happened to be when housing prices were at their highest. The subsequent market crash resulted in prices plummeting while mortgage balances remained at their refinanced highs. In the unfortunate event of a foreclosure, homeowners may be faced with unexpected taxable gains.
Calculating Your Foreclosure Gain/Loss
To determine the tax implications of a foreclosure the taxpayer must first establish if the mortgage on the property is recourse or non-recourse. This can be determined by contacting the taxpayer’s mortgage lender. In a non-recourse mortgage the lender is only able to seize the borrower’s property and sell it to recover losses. To the extent the property is sold for less than the amount the borrower owed, the lender bears the risk of loss. In a recourse mortgage the lender can pursue both the property and the borrower’s other personal assets in order to make the lender whole.It is these gains that are the subject of this article. Guidance will be provided on determining the type of foreclosure, calculating the resulting gain or loss, and exclusions that may be used to reduce taxable gains.
Once the type of mortgage is determined, the taxpayer can compute the gain or loss resulting from foreclosure. The gain or loss on foreclosure is computed the same way as a normal sale of property, which is the amount realized less the adjusted basis of the property. In a foreclosure involving a non-recourse mortgage, the amount realized is the mortgage balance. In a foreclosure involving a recourse mortgage, the amount realized is the lesser of the fair market value of the property or the mortgage balance. The adjusted basis is the same for both scenarios which is the original cost of the property plus additions less deductions (depreciation, casualty loss). If you find this confusing, you’re not alone. The best way to gain an understanding of these rules is to analyze an example:
Example: Tax Consequences on Jimmy’s Foreclosure
Jimmy purchased a property for $400,000 with a down payment of $50,000 and a mortgage of $350,000. Home values rose over the next few years and Jimmy refinanced his home for its full value at the time or $500,000. The housing recession hit Jimmy by surprise and three years after he refinanced, his home was worth $430,000 and the mortgage was paid down to $450,000. What is Jimmy’s gain or loss if his home is foreclosed upon?
If the mortgage was Non-Recourse
Fair Market Value = $430,000. Adjusted Basis = $350,000. Mortgage Balance= $450,000.
Jimmy would recognize a capital gain of $100,000. As stated earlier, the gain or loss will be the excess of the amount realized (mortgage balance of $450,000) over the adjusted basis of the property [$350,000]. The fair market value is irrelevant when the mortgage on a property in foreclosure is non-recourse. Also, this type of foreclosure cannot result in income from the cancellation of debt.
If this property was Jimmy’s principal residence he may be able to exclude the gain under Section 121. Section 121 is a common exclusion for homeowners who sell their principal residences in which they have lived in for at least two out of the past five years.
If the mortgage was Recourse
Fair Market Value = $430,000. Adjusted Basis = $350,000. Mortgage Balance= $450,000.
Jimmy would recognize a capital gain of $80,000 and, assuming the lender forgave the excess of the loan balance over the FMV of the property, income from the cancellation of debt of $20,000. The fair market value is relevant when the mortgage on a property in foreclosure is recourse. When computing the gains or losses of a foreclosure involving recourse debt, first one must calculate the capital gain or loss. As discussed earlier, the gain or loss will be the difference between the amount realized and the adjusted basis on the property [$430,000 FMV minus $350,000 basis]. In recourse situations, the amount realized is the lesser of the fair market value or the mortgage balance. Logically, however, the FMV of a foreclosed property will almost always be less than the mortgage balance, or else the property owner could merely sell the property and pay off the mortgage in full.
Next, one must compute any cancellation of debt income, which is the excess of the mortgage balance less the fair market value of the property [$450,000 – $430,000 = $20,000]. Cancellation of debt income is generated when the fair market value is less than the mortgage balance, i.e. the lender cannot pay off the whole mortgage by selling the property.
So one may be wondering, why does it matter if a foreclosure gives rise to only capital gain (as in the non-recourse example) or a mixture of capital gain and cancellation of debt income (as in the recourse example)? They both give rise to the same total gain, correct?
Yes, but with potentially different tax results. Depending on the situation, the cancellation of debt income may be inaudible whereas the capital gain is not, or vice versa. For example, income from the cancellation of debt cannot be excluded by Section 121 (principal residence), but can be excluded by Section 108 (insolvency and other exclusions). To the contrary, a capital gain from the foreclosure of a qualifying principal residence may be excluded by Section 121, but not Section 108.
Covering the intricacies of these tax laws would turn this article into a half day seminar. Just knowing that different types of income can result from a foreclosure involving a recourse mortgage is more than enough.
To really nail down an understanding of these concepts, assume Jimmy was really unlucky, and his house value dropped all the way to $330,000.
If the mortgage was Recourse and Jimmy was really unlucky
Fair Market Value = $330,000. Adjusted Basis = $350,000. Mortgage Balance= $450,000.
Jimmy would recognize a loss of $20,000 and income from the cancellation of debt of $120,000! The loss is calculated as the difference between amount realized and the adjusted basis [$330,000 FMV minus $350,000 basis]. Despite the fact that Jimmy has recognized a loss on this aspect of the foreclosure he must still recognize cancellation of debt income to the extent the forgiven mortgage balance exceeds the fair market value of the property [$450,000 – $330,000 = $120,000].
If the property was personal the loss would be non-deductible and income from the cancellation of debt would not be excludible under Section 121, but could potentially be excludable under one of the other exceptions found in Section 121. If the property were an investment property, the loss would be capital.
The Take Away
As you can see, the tax treatment of properties in foreclosure can get a little complicated. I will briefly summarize the key points I want you to take away from all of this.
- It is wise to consider the tax implications of a foreclosure before it takes place. For both personal and investment properties, a plan may help reduce the tax burden.
- Mortgages on properties can be either recourse or non-recourse. Knowing the distinction can aid in determining the type of gain or loss in the event of a foreclosure
- In a foreclosure involving a non-recourse mortgage the fair market value is irrelevant. To the extent the mortgage balance exceeds the properties adjusted basis the taxpayer will recognize a gain.
- In a foreclosure involving a recourse mortgage, fair market value is relevant and the foreclosure can result in both income from the cancellation of debt and a capital gain or loss.
- The two types of gains may be offset by various IRS exclusions, most notably, those found in Section 121 and, Section 108.
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