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Foreclosures

Foreclosure can trigger capital gains and canceled debt income

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Foreclosures are treated as the sale of property for federal tax purposes. Homeowners going through a foreclosure will need to calculate their gain or loss for tax purposes, as well as consider any income tax that might be due on the forgiveness or cancellation of debt. These are two separate issues: gain on the sale of the property and imputed income from any debt forgiveness.

Capital Gain or Loss on Foreclosures

In usual circumstances, the sale of real property goes through escrow, and the seller receives statements showing how much the home was sold for. With foreclosures, however, there is no escrow. The lending bank simply takes possession of the house. A foreclosure is still considered a sale, or in more technical terms, a "disposition" of property. When property is disposed of, the owner calculates any gain or loss on the transaction for tax reporting purposes.

Now the basic formula for capital gains is to subtract the basis or cost of the property from the selling price. The difference is how much profit a person made, or how much money was lost on the transaction. In a foreclosure situation, the selling price used for tax purposes isn't immediately clear because there's no escrow statements and no mutually agreed upon selling price. However, there is still a "selling price" for tax purposes: it will be either the fair market value of the property or the outstanding loan balance immediately prior to the foreclosure. Both of these figures will be reported to you by the bank using Form 1099-A. Which figure you will use depends on what state you live in and what type of loan you had.

Recourse or Non-Recourse Loans

The selling price (for tax purposes) of the property is determined by whether the loan or loans securing the property are recourse loans or non-recourse loans. According to About.com's banking and loans expert Justin Pritchard, mortgages used to acquire a house tend to be non-recourse loans, while refinanced loans and home equity loans tend to be recourse loans. Be aware that how home loans are classified depends on state lending laws. For more information, see Recourse Loans and Non-Recourse Loans.

Accordingly, you will first need to determine what type of loan you had on your property. From there, you can determine the selling price. You may need to analyze your loan documents to extract the information you need for your income tax reporting.

Determining the Selling Price

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. 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.
Also note, with recourse loans, the borrower may have canceled debt income arising from the foreclosure.

A non-recourse loan, by contrast, 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. 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.

Note that with non-recourse loans, the borrower will not have any canceled debt income, because the lender is prohibited by law from pursuing the borrower for repayment.

Reporting Capital Gain or Loss

If the foreclosed property was your primary residence, you report the foreclosure sale on your Schedule D, and you may qualify to exclude up to $250,000 of gain from income tax.

If the foreclosed property was a personal use property, but not your primary residence, such as a second home or vacation home, then you'll report the foreclosure sale on your Schedule D.

If the foreclosed property was mixed use (was your primary residence at one time, and was a secondary residence at another time), then you'll need to utilize the modified rules for calculating your gain or loss.

If the foreclosed property was a rental property, then you'll report the sale on Form 4797.

Canceled Debt Issues

Foreclosures can trigger taxable income besides capital gains. If the lender forgives or cancels the mortgage debt on a recourse loan, 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. This tax exclusion expires at the end of the year 2013.

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 Reporting Documents Form 1099-A and Form 1099-C

Form 1099-A is issued by the bank after real estate has been foreclosed, and reports the the date of the foreclosure, the fair market value of the property, and the outstanding loan balance immediately prior to the foreclosure. You will need this information when reporting any capital gain income related to the foreclosure.

Form 1099-C is issued by the bank after the bank has canceled or forgiven any debt on a recourse loan. The form will indicate how much debt was canceled. If a lender both forecloses on a home and cancels the unpaid debt in the same year, you may receive only a single Form 1099-C that reports both the foreclosure and the cancellation of debt (instead of receiving both a 1099-A and a 1099-C).

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