Foreclosures and short sales are treated as the sale of property for tax purposes. Homeowners going through a foreclosure or short sale (pre-foreclosure), will need to calculate their gain or loss for tax purposes, as well as consider any tax that might be due on the forgiveness or cancellation of debt.
** Note the Mortgage Debt Relief Act of 2007 generally allows tax payers to exclude the discharge of debt on their principle residence, this includes mortgage debt forgiven in connection with a short sale. This protection is available until 2014, however, there after the following would apply.
Determining the Selling Price
The basic formula for capital gains is to subtract the basis or cost of the property from the selling price. In a foreclosure situation, the selling price used for tax purposes depends on whether the loan was a recourse or a non-recourse loan. A recourse loan is a loan where the borrower is personally liable for the debt, and the lender can pursue repayment even after the property has been repossessed.
A non-recourse loan is a loan where the borrower is not personally liable for repayment of the loan; in other words, once the lender repossess the property used to secure the loan, the loan is satisfied and the lender cannot pursue the borrower for further repayment.
Mortgages used to acquire a house tend to be non-recourse loans but may be either recourse or non-recourse and how these loans are classified depends on local state lending laws. Refinanced loans and home equity loans tend to be recourse loans. For more information, see Recourse Loans and Non-Recourse Loans.
Determining Gain or Loss on a Foreclosure
For recourse loans, the figure used as the selling price is the lower of the following two amounts:
- the outstanding loan balance immediately before the foreclosure minus any debt for which the borrower remains personally liable after the foreclosure; or
- the fair market value of the property being foreclosed.
For non-recourse loans, the figure used as the selling price is the outstanding loan balance immediately before the foreclosure. You are considered as selling the house to the lender for full consideration of the outstanding debt.
Canceled Debt Issues
Foreclosures can trigger taxable income besides capital gains. If the lender forgives or cancels the mortgage debt, that may need to be included as income unless an exception applies.For recourse loans, the amount of debt canceled by the lender is potentially taxable income. There are a number of exceptions that exclude canceled debts from tax treatment. The most important of these is the exclusion for debt secured by your main home. Under the Mortgage Forgiveness Debt Relief Act, canceled debts of up to $2 million can be excluded as long as the debt was used to buy or build your principal residence. The Emergency Economic Stabilization Act extends this debt relief through 2014.
For non-recourse loans, there is no cancellation of debt income to be reported. That’s because the lender cannot pursue the borrower for repayment of the debt, even if the fair market value of the property is less than what was owed.
Tax Consequences for a Primary Residence
A main home is real estate used as the primary residence of the taxpayer. If a main home is foreclosed, the individual has several exclusions available to shield themself from taxes. First, any capital gains on a main home can be excluded, up to $500,000 for married couples or $250,000 for unmarred persons.
Second, if the mortgage loan was a non-recourse loan, the borrower would have no canceled debt income to report.
Third, if the mortgage loan was a recourse loan, the borrower can take exclude up to $2 million of canceled debts if the loan proceeds were used to buy or build a primary residence. Home equity loans can potentially be excluded from tax as well using the exclusion for insolvency (you are insolvent when your total debts are more than the fair market value of your total assets).
Tax Consequences for Property Other than a Main Home
Second homes, vacation property, and rental properties can be foreclosed. Capital gains and canceled debt income are calculated in the same way. However, these properties do not qualify for the $2 million exclusion, nor do they qualify for the $250,000 capital gains exclusion; these two exclusions apply only to a main home. Still, borrowers can shield themselves from taxes by using the various exclusions for canceled debts. In particular, it is likely that taxpayers will qualify for the insolvency exclusion.
Owners of rental property will want to take note of the depreciation recapture tax. This is a special type of capital gains tax based on the amount of depreciation deducted against the rental income.
If you’re facing foreclosure you’re facing some very important decisions. We want you know you’re not alone and we are here to help with any questions you may have to assist you in making the best decisions for your situation. There is no charge for this service and we are happy to help! We offer confidential and professional real estate advice.
The Opland Group Specializes in Real Estate Sales, Luxury Home Sales, Short Sales in; Bexley Columbus Delaware Downtown Dublin Gahanna Grandview Heights Granville Grove City Groveport Hilliard Lewis Center New Albany Pickerington Polaris Powell Upper Arlington Westerville Worthington
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