If you recently suffered a foreclosure, you may not realize that you have traded your mortgage debt for tax debt. The Internal Revenue Service treats foreclosure like any other sale of property. If you are personally responsible for some of the mortgage debt that has been canceled or written off, you may have to account for capital gains and pay taxes on it. Only How? ‘Or’ What and whether you will pay these taxes depends on the type of loan and the property involved.
You may have to report capital gains
After your home is foreclosed, if the property sells for more than you owe, you may have to realize capital gains on the transaction, known as a surplus.
Your bank or lender will report this amount on Form 1099-A and mail a copy to you. Lenders should send a copy by February 28, but if you haven’t received this form yet, you should contact your financial institution. If you have capital gains to report, the reported amount of those gains will depend on whether the loan was a recourse loan or a non-recourse loan.
A recourse loan is a loan for which you are personally liable. Most mortgages, home equity loans, home equity lines of credit (HELOCs), or subordinated loans on property are recourse loans. The same is true for most primary mortgages, except in these 12 states:
- North Carolina
- North Dakota
With this type of debt, the capital gain is the difference between the sale price and the property’s adjusted basis – usually the cost of the property, plus the value of any improvements you have made to it, minus any loss you may have made. she could have suffered any type of damage. Since a foreclosure does not have an agreed sale price, you can use the smaller one instead:
(1) The amount of money you owed immediately before the foreclosure (any outstanding loans, liens, or unpaid taxes) minus any amount for which you are still personally liable after the sale, or
(2) The fair market value of the transferred property. According to the IRS, this is usually the gross price of the foreclosure offer. This value is usually used when the bank makes this offer, rather than a third party.
If you owe a balance left after foreclosure, the lender can potentially sue you and have your wages garnished, a bank account taken, or a sale of another asset forced.
For non-recourse loans, that is, debts for which you are not personally responsible, the selling price is the total amount of the debt just before the foreclosure. The capital gain is the sale price minus the adjusted basis of the property. If the sale results in a loss – called a deficit – you are not responsible for the amount still owed. This is why the loan is known as a non-recourse loan.
To report capital gains, use IRS Form 4797. You must also report Schedule D, Capital Gains and Losses.
You may be able to exclude capital gains
If you have capital gains to report, one of the most important tax benefits you can take advantage of is the “principal place of residence” exclusion. If you lived in your home and owned it for a total of two years in the last five years, you can exclude up to $250,000 of capital gains, or up to $500,000 if you’re married and you are filing jointly. This exclusion can help rid you of any tax liability.
You may need to account for debt cancellation proceeds (CODI)
If your home was on a recourse loan, you may have to pay taxes if the lender forgives some of your debt. The IRS counts any now forgiven amount you owe the lender as income – as if it were a payment that took you out of the red and back to zero. In the eyes of the IRS, this amount is an economic benefit and could result in a tax liability.
You can use the IRS Table 1-1 for Foreclosures and Repossessions worksheet if you have a CODI. CODI may generate ordinary income and you must include it in your gross income. If your forgiven debt is $600 or more, the lender must issue you Form 1099-C, Cancellation of Debt.
Suppose Mr. Simpson bought a four-bedroom house on January 1, 2010 for $400,000 with a recourse loan from Burns & Smithers Bank. In January 2019, Mr Simpson took out a $15,000 home loan from the same bank to cover some emergency expenses. On January 1, 2020, Mr Simpson lost his job at the local power station, leaving him unable to pay both the original mortgage and the home equity loan. Oh ! As of May 1, 2021, the home had been foreclosed, selling for $320,000, its full market value.
At the time of the sale, Mr. Simpson owed $320,000 on the original loan and $14,000 on the subordinated loan. Burns & Smithers Bank canceled $1,000 of the home equity loan and issued him a 1099-C on January 31, 2022. Unless an exclusion applies, Mr. Simpson will have to report that $1,000 in the part of his income. But before Mr. Simpson rips out what’s left of his hair, he might be able to take advantage of an escape route.
You may be able to exclude some of your canceled debt from your income
Under the Mortgage Debt Relief Act 2007 (extended from 2021 to 2025), you can exclude any forgiven debt from the mortgage you took on to buy, build or significantly improve your home up to 750 $000. This is called the Qualified Principal Residence Debt Exclusion (QPRI).
If you are able to avail yourself of this provision, you must report it to Form 982 and attach the form to your tax return.
You may be eligible for additional relief if you are insolvent
If you can’t take advantage of the Mortgage Debt Relief Act, you can still take advantage of the IRS’ insolvency exclusion. If you were insolvent – if what you owe exceeds the value of what you own – just before the foreclosure process cancels your mortgage debt, you can leave some or all of that debt canceled on the income you must report at the IRS.
If you qualify, start by checking box 1b on IRS Form 982 and report the canceled debt on line 2. Then use the amount of canceled debt to reduce certain tax benefits you would otherwise get.
The IRS doesn’t want to let you profit twice from your misfortune. So if you reported a loss for selling stocks or bonds for less than you paid; if you have certain tax credits in your favour; or, among other situations, if any property you own has been damaged or otherwise lost value, the amount of your forgiven debt could also wipe out some or all of the tax relief you would get from these scenarios. This is called tax attribute reduction, and it is captured in Part II of Form 982.
By reducing your tax benefits, tax on canceled debt is partly deferred, but not entirely forgiven. For example, if you reduce the base of the property, but later sell the property with a gain, the part of the gain you got from that base reduction is taxed as ordinary income.
Use the dollar amount of your debt forgiveness to cancel your tax attributes in the following order:
- Net operating loss of any business
- General Business Credit Deferral
- Alternative minimum tax credit
- Capital loss
- The cost basis of the asset
- Loss of passive activity
- Foreign tax credit deferral
If you qualify for this provision, the IRS urges you to carefully follow instructions for form 982.
There’s light at the end of the tunnel
Foreclosure on your home can be a painful process. Dealing with the associated taxes can be daunting. But if you receive a 1099-A or 1099-C, you don’t need to panic. You may be eligible to exclude some or all of your capital gains or CODI from income using the strategies outlined above, ending tax season with a little less tax debt and less stress.