Jakemann Racing

You have just lost your home when your lenders foreclosed, and out of the blue, to add insult to injury, you are hit with a tax demand.  Unjust and unfair as this may sound, it can happen unless you clearly understand the tax implications of foreclosure.  While some reliefs that have been provided by the Mortgage Forgiveness Debt Relief Act, not all foreclosed homeowners are benefited.  The problem arises because under tax statute, a foreclosure is treated as a sale while debt forgiveness is treated as income.  When your lender forecloses, he will issue to you a form 1099 C which will show that he has received the property and that you have received cash or other property.  This will mean that the proceeds are taxable unless you qualify for an exception.  Exceptions are, for instance, available if you have declared bankruptcy or if you are an insolvent

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. 

Brought to you by Automated Homefinder – your real estate experts in:
Boulder Colorado
Longmont Colorado
Nederland Colorado
Lafayette Colorado
Firestone Colorado.