Foreclosures and Your Income Tax
Deemed Sale
When you lose your home to foreclosure, or the property is given back to the lender (Deed in lieu of foreclosure), a deemed sale or exchange has taken place under Section ยง1001(a) of the Internal Revenue Code. This sale or exchange of property could result in a tax gain or loss, and the recognition of cancellation of debt (COD) income to the taxpayer. Cancellation of indebtedness will result in taxable income to the taxpayer unless there is an exception within the statute (IRC Section 108) which is beyond the scope of this article. One important factor that will determine the treatment for tax purposes, is whether your loan is Recourse or Non recourse.
Tax Treatment of Your Foreclosure
When an asset is sold, the difference between the amount realized and the taxpayers "adjusted basis" in the asset will determine the amount of the gain or loss recognized. The Amount realized will either be the fair market value of the property (FMV) or the face value of the debt, depending on whether the debt is classified as recourse or non-recourse. Accordingly, if the debt is non-recourse, the amount realized is going to be the face value of the debt, creating more gain, but no cancellation of debt income. Conversely, if the debt is recourse, less gain is recognized, because the FMV of the property as of the sale date, is used instead, but there is the possibility of having to recognize COD income. This COD income will be the difference between the Face value of the debt and the FMV of the property.
Know Your State laws Consumer Laws
The tax treatment of your home foreclosure is going to depend on whether your home loan was a Recourse or Non-Recourse loan. Some States have laws preventing banks from coming after homeowners on unpaid loan balances, for primary residences, which creates a non recourse situation.
Recourse Loan:
1-The amount realized is the FMV of the Property.
2-The adjusted basis is what you paid for the property or acquisition cost, plus capital improvements.
If the property was a rental, then you have to subtract depreciation from the adjusted basis.
3-Cancellation of debt income is the difference between the fair market value and the face value of the debt.
4-Gain or loss is the difference between the fair market value and the adjusted basis.
5-Attribute reduction and/or the elimination of deductible losses due to any forgiven debt income exclusion, under IRC Section 108, due to the debt cancellation, must also be calculated, which is outside the scope of this article.
Non Recourse Loan
1-The amount realized is the Face value of the debt.
2-The adjusted basis is what you paid for the property or the acquisition cost as in (2) above.
3-Cancellation of debt income is not an issue with recourse debt.
4-The gain or loss is the difference between the face value of the debt and the adjusted basis.