Let us take a little time to understand the taxation problem in detail. A foreclosure will be regarded as a sale at the Fair Market Value (FMV) of the house The difference between the FMV and the tax basis [which is defined as the cost of acquisition of the house plus the cost of any improvements] will therefore result in a capital gain or a capital loss as the case may be.  In addition, if the lender cancels or forgives a part of the debt, as is quite a common these days, the amount so canceled is taxable as Cancellation of Debt (COD) income unless you are entitled to an exception.  In the case of a capital gain you are allowed exclusion as federal home gain exclusion provided the home has served as your principal residence for two of the past five years.

  For example, if your house is sold for its FMV of $500,000 and your tax basis is $300,000; your capital gain is $200,000.  If the lender has forgiven you debt of $100,000, your taxable COD income is $100,000.  In the absence of any exceptions, both the capital gains and the COD income are fully taxable.

The first problem is that in many cases, in the heyday of profligate mortgage lending, people often took out a second mortgage or a home equity loan on their principal residence to pay off high interest credit card debt. In many cases, the lender’s themselves would have required the borrower to consolidate or settle credit card debt This portion of the debt will not be included for the calculation of the tax basis since it was used neither for acquisition or for improvement.   The second problem is that the relief only applies to the principal residence and second homes, vacation homes and investment properties do not qualify.  So any debt for acquisition or improvement of any property other than the principal residence does not qualify for relief.

Even in the case of solvency or bankruptcy, you must be insolvent at the time of foreclosure or have filed for bankruptcy before the foreclosure takes place.

You must clearly understand that the purpose of this article is merely to alert you to the possible tax consequences of foreclosure.  You should seek expert advice in your own individual case in order to establish the taxability or otherwise under both federal and state statute. 

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A foreclosure is initiated by a mortgage lender when the house owner is delinquent on his debt payments. If he has been in financial trouble for some time, it is likely that he has neglected essential repairs and maintenance on the house. This may be a desirable factor if you simply want to “flip” the house in other words resell for a quick profit.

Otherwise any discounts on the price that you can obtain can easily be swallowed up by the cost of repairs required to make the house inhabitable. Also bear in mind that many lenders and banks are really aware of ruling property prices and are not desperate to get rid of the property at any cost.

You can acquire the property at auction but this is not to be recommended for many reasons for inexperienced foreclosure buyers.

Auctions often have onerous conditions on items like payment and inspection and are best left to the professionals. You can also negotiate directly with the bank or a lender but you are unlikely to get any real bargains unless the property in question is badly rundown or otherwise un-salable. Your best chance of getting a good deal is to make direct contact with the homeowner either before the foreclosure commences or before it is complete. You will need to be resourceful in trying to find potential sellers before foreclosure commences because this represents your best chance of a deal [you can for instance check at the court house to see what eviction notices have been issued].
Typically in these cases, in addition to the price of the house, you will probably be required to pay an agreed potion of the owner’s home equity in cash.

Here are some sensible precautions you should take before negotiating for a foreclosed property:

- You need to be sure that the homeowner is not entitled to stay on for a prolonged period after foreclosure

- consult a lawyer if necessary about redemption rights for the homeowner. This means that he has an irrevocable right to rectify his default after paying his debts is all associated costs and regain his property

- make sure you’re the type of person who has no misgivings about taking advantage of somebody else’s misfortune. Make no mistake this is not easy for an ordinary decent person.

- examine and the records to make sure that there are no lesions or
claims on the property as settling these will drive up the price.

As you can see, getting a good deal out of a foreclosure is not as easy as it seems and you may consider it wise to appoint a real estate agent who specializes in foreclosures.

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