If you thought a bank foreclosure ended the financial miseries associated with your former home, think again.
If you thought a bank foreclosure ended the financial miseries associated with your former home, think again. You could soon be hearing from the IRS about taxes due in connection with the residence you no longer own.
“You can walk away from the big house payment, but not from the potential tax implications,” says John Roth, senior tax analyst at CCH in Riverwoods, Ill. “And if you couldn’t afford the mortgage, you probably can’t afford the taxes.”
As the lending crisis continues to shake out, more homeowners, particularly those who used creative mortgages to buy their houses, could be in this predicament. Even longtime homeowners who refinanced their properties based on increased value when the real-estate market was hot could find themselves in tax trouble if they lose their properties to the bank.
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The issue is complicated by many factors. There are, of course, the financial problems that have led to the foreclosure process. Add to that the loan terms, the housing market in your area and, of course, federal tax laws, and you’ve got a recipe for financial disaster.
In many cases, the tax problem associated with a foreclosure arises from a seemingly benevolent move — the lender forgives some of the loan. This happens when a lender and a borrower negotiate a reduction in loan amount. It also happens when the lender forecloses on the property and sells it for less than the outstanding mortgage.
In both instances, the difference for which the borrower is no longer responsible is usually considered cancellation of debt, or COD income. It also is called discharge of indebtedness income or discharge of debt. Regardless of the name, under the tax code, it’s all taxable income. The tax on COD is calculated at ordinary rates, which range from 10 to 35 percent depending upon your income.
“What the tax law essentially does is treat the foreclosure as a sale by the debtor, the owner of the property, with the proceeds being paid to the lender,” says Frederick Stein, RIA senior analyst from Thomson Tax & Accounting. “And any debt owed above and beyond those proceeds is cancellation-of-indebtedness income.”
That’s why financially struggling homeowners who are considering turning over the house keys to the bank should think twice. While sending the lender “jingle mail,” a term coined to describe the sound of a key-containing envelope, will get you out from under the burden of the monthly house payment, it won’t prevent a tax bill in your mailbox.
“People who advise you to walk away talk about payment consequences, not the tax consequences,” Stein says. “If they owe $50,000 and $10,000 is forgiven, they think of it as a gift. It may be a gift from the lender, but not from the IRS.”
Roth adds, “The IRS is far more tenacious than most banks. Their responsibility is to collect the tax on the income you have.”
Type of mortgage matters
Just how much and what type of tax the IRS expects after a foreclosure depends in large part on whether the loan is of the recourse or nonrecourse variety.
With a recourse loan, the debtor is personally liable for the debt. In a foreclosure, it means if the property-sale proceeds are not enough to cover the outstanding mortgage, the debtor must pay the difference. This includes interest that accrues during the foreclosure process.
A nonrecourse debt, however, is secured by the loan collateral. If money from sale of the property doesn’t cover the outstanding debt, the lender has no legal ability to get the additional funds from the debtor.
“In nonrecourse situations, you have a house, the mortgage and the market value of whatever the bank can sell it for and put toward the outstanding loan,” says Ted Lanzaro, a CPA in Shelton, Conn. “If the house is worth $100,000 and there is a $110,000 loan on it, the bank in a nonrecourse situation cannot go after the borrower for that $10,000 difference.”
Cancellation of debt income and its tax implications typically come into play with recourse loans. If the house’s fair-market sale price is less than the unpaid mortgage and the lender forgives the remaining mortgage debt, that amount is taxable income at ordinary tax rates.
With either type of mortgage, a foreclosed-upon homeowner could end up owing capital-gains taxes without ever receiving any money from the foreclosure sale.
A sale is a sale is a sale
“Foreclosure is not a sale in normal terms, but it is still treated under tax code as a sale,” says Stephen Trenholm, tax manager at Rucci Bardaro & Barrett in Boston. “The outstanding balance of the mortgage is compared with the basis in house. If that produces a gain, it’s a taxable gain. If it’s a nonrecourse mortgage, it’s a capital gain.”
That’s right. Even though you aren’t selling the house and the bank is, the IRS views the transaction as if you were the seller. That means you could owe taxes on the sale. The bad news comes directly from the IRS, via Publication 544.
Let’s assume the example homeowner mentioned earlier has nonrecourse mortgage debt of $110,000 and an adjusted basis of $20,000 in the home, which has a fair-market value of $100,000. The owner has no ordinary tax liability for that $10,000 difference in his debt and the home’s value. But when a nonrecourse mortgage is foreclosed and that debt is greater than the home’s value, the property is treated for tax purposes as if it were sold for the balance of the mortgage.
That means this homeowner would have a $90,000 difference between the mortgage debt and his basis ($110,000 less $20,000) and that $90,000 is taxable capital gain from the “sale or other disposition” of the home. So even though the foreclosed-upon owner didn’t get any cash from the transaction, he still owes taxes on what is known as phantom income. The only good news is that the taxes are collected at the lower 15 percent (or 5 percent for lower-income taxpayers) capital-gains rate.
If that same homeowner’s mortgage was recourse debt and his lender canceled the $10,000 difference between the outstanding loan and the home’s fair market value, the foreclosed-upon owner would owe higher, ordinary taxes on that forgiven 10 grand. In addition, his capital-gains bill would be based on $80,000 — the property’s fair-market value of $100,000 less his $20,000 adjusted basis.
For some struggling homeowners, the taxes on forgiven debt or phantom income are all too real.
“If it’s $10,000, that’s a relatively small spread; $2,000 to $2,500 in federal and state taxes,” Lanzaro says. “But it’s not just the working man having this problem. Everybody’s getting in over their head these days.
“If you have a $700,000 mortgage and the bank can only get $500,000 in a foreclosure sale, now you’re talking about some tax liability.”
And don’t think the IRS won’t find out. The agency has a mechanism to catch foreclosure sales. The lender is supposed to issue a 1099-C to alert the former homeowner and IRS of the canceled debt and, in certain cases, the market value of the foreclosed property.
There is one bit of good news for our hypothetical homeowner and others dealing with foreclosure-induced taxes. You can get out from under at least part of the IRS bill if you meet the homeownership tax-exclusion rules.
This popular tax break allows a single homeowner who sells his property under more favorable circumstances to exclude $250,000 in profit from taxes; the exclusion is $500,000 for married couples filing jointly.
The exclusion also applies in foreclosures. As long as the “seller,” in this case the foreclosed-upon owner, lived in the home as his principal residence for two of the past five years, he also can avoid taxes on any capital-gain profit, phantom or real.
Two other circumstances offer tax relief in foreclosures, but both could cause other financial problems.
If homeowner’s insolvent
If a homeowner can show he’s insolvent before the discharge of the mortgage and turnover of the property, as well as afterward, any proceeds are not taxed. However, Trenholm says, “insolvency is a little tricky. There’s no strict definition of what assets [go in the calculation], but for the most part, a lot of people caught in the real-estate crunch can establish that condition.”
The other option is bankruptcy.
“Forgiveness debts, in these cases, are not taxed,” Roth says. “They don’t want the bank chasing them down, which is why many times people going through foreclosure also go through bankruptcy.”
However, filing for bankruptcy has its own set of considerations. “New bankruptcy rules don’t give [filers] a lot of relief,” says William Bost, a member of the Raleigh, N.C.-based law firm Ragsdale Liggett. “If you have a job and are making money, the new bankruptcy rules don’t give you a whole lot of help. It gives you some time, but I don’t think that’s necessarily the way to go.
“It used to be like going to church: You walk in and walk out absolved. But it’s not like that anymore,” Bost says. “Now, it’s not worth the pain you pay the rest of your life.”
One thing lending and tax experts all agree on: If you’re facing foreclosure, take action as soon as you realize you’re in trouble. And get professional help to determine exactly what your personal tax labiality might be in the transaction.
Lanzaro has two other recommendations: “The best advice is, don’t buy a house you can’t afford, and don’t get an adjustable-rate mortgage.”
If you’re stuck with more house than you can pay for, there are a couple of options in addition to foreclosure.
Each, however, still has tax and other potential long-term financial implications.
• Short sale: This real-estate transaction has become popular among homeowners who are having problems making payments on a mortgage that is more than their house is worth. Rather than waiting for the bank to foreclose, the owner works with the lender to complete a sale of the home for less than the loan balance.
“You have a property you’re just trying to get out from under,” says Paul Haarman, vice president of Renaissance Mortgage in Salem, N.H. “Everybody is all lined up at the table and the buyer buys the property and the lender agrees to the price. You have a $250,000 debt, the bank nets only $220,000 and that $30,000 is written as a foreclosure shortage.”
A short sale keeps a foreclosure from showing up in your credit record, but the shortfall will appear there as a delinquent loan. It’s not as bad as a foreclosure, but, says Bost, “It’s on the credit report and, as a [future] borrower and consumer, it will haunt you.”
• Deed-in-lieu of foreclosure: In this case, Trenholm says, the homeowner basically says to the lender, “I want to save you some time, some money. How about I just turn over the property?”
This way the foreclosure process is avoided, which will help the borrower, because it won’t show up on a credit record. However, it could still show up on a credit report as forgiven debt.
This process has “pretty much the same tax consequences as a foreclosure,” Trenholm says. Because you are being relieved of the indebtedness on the property, for tax purposes it’s still considered sale of the property.
The argument for short sales and deeds-in-lieu is that they are beneficial to strapped borrowers. From a tax and financial perspective, however, they don’t really matter.
“All of these situations are basically the same,” Stein says. “The mechanics and timing may be a little different, but essentially in all of them at some point a lender is saying to the borrower you don’t have to pay the rest of what you owe. When he tells the borrower that, that’s cancellation of indebtedness income.”
“The only benefit,” Bost says, “is the ‘it’s over’ factor.”