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If you thought a bank
foreclosure ended the financial miseries associated with
your former home, think again. You could soon be hearing
from the IRS about taxes due in connection with the
residence you no longer own.
"You can walk away from the big house payment, but not from
the potential tax implications," says John W. Roth, senior
tax analyst at CCH in Riverwoods, Ill. "And if you couldn't
afford the mortgage, you probably can't afford the taxes."
As the lending crisis continues to shake out, more
homeowners, particularly those who used creative mortgages
to buy their houses, could be in this predicament. Even
long-time homeowners who refinanced their properties based
on increased value when the real estate market was hot could
find themselves in tax trouble if they lose their properties
to the bank.
The issue is complicated by many factors. There are, of
course, the financial problems that have led to the
foreclosure process. Add to that the loan terms (some of
which employed those creative mortgage products), the
housing market in your area and, of course, federal tax
laws, and you've got a recipe for financial disaster.
Forgiven but not forgotten
In many cases, the tax problem associated with a foreclosure
arises from a seemingly benevolent move -- the lender
forgives some of the loan. This happens when a lender and a
borrower negotiate a reduction in loan amount. It also
happens when the lender forecloses on the property and sells
it for less than the outstanding mortgage.
In both instances, the difference for which the borrower is
no longer responsible is usually considered cancellation of
debt, or COD income. It also is called discharge of
indebtedness income or discharge of debt. Regardless of the
name, under the tax code, it's all taxable income. The tax
on COD is calculated at ordinary rates, which range from 10
percent to 35 percent depending upon your income.
"What the tax law essentially does is treat the foreclosure
as a sale by the debtor, the owner of the property, with the
proceeds being paid to the lender," says Frederick M. Stein,
RIA senior analyst from Thomson Tax & Accounting. "And any
debt owed above and beyond those proceeds is cancellation of
indebtedness income."
That's why financially struggling homeowners who are
considering turning over the house keys to the bank should
think twice. While sending the lender "jingle mail," a term
coined to describe the sound of a key-containing envelope,
will get you out from under the burden of the monthly house
payment, it won't prevent a tax bill in your mailbox.
"People who advise you to walk away talk about payment
consequences, not the tax consequences," says Stein. "If
they owe $50,000 and $10,000 is forgiven, they think of it
as a gift. It may be a gift from the lender, but not from
the IRS."
Roth adds, "The IRS is far more tenacious than most banks.
Their responsibility is to collect the tax on the income you
have."
The type of mortgage matters
Just how much and what type of tax the IRS expects after a
foreclosure depends in large part on whether the loan is of
the recourse or nonrecourse variety.
With a recourse loan, the debtor is personally liable for
the debt. In a foreclosure, it means if the property sale
proceeds are not enough to cover the outstanding mortgage,
the debtor must pay the difference. This includes interest
that accrues during the foreclosure process.
A nonrecourse debt, however, is secured by the loan
collateral. If money from sale of the property doesn't cover
the outstanding debt, the lender has no legal ability to get
the additional funds from the debtor.
"In nonrecourse situations, you have a house, the mortgage
and the market value of whatever the bank can sell it for
and put toward the outstanding loan," says Ted Lanzaro, CPA
and owner of his own accounting firm in Shelton, Conn. "If
the house is worth $100,000 and there is a $110,000 loan on
it, the bank in a nonrecourse situation cannot go after the
borrower for that $10,000 difference."
Cancellation of debt income and its tax implications
typically come into play with recourse loans. If the house's
fair market sales price is less than the unpaid mortgage and
the lender forgives the remaining mortgage debt, that amount
is taxable income at ordinary tax rates.
With either type of mortgage, a foreclosed-upon homeowner
could end up owing capital gains taxes without ever
receiving any money from the foreclosure sale.
A sale is a sale is a sale
"Foreclosure is not a sale in normal terms, but it is still
treated under tax code as a sale," says Stephen Trenholm,
CPA, MST (master's degree in taxation) and tax manager at
Rucci Bardaro & Barrett in Boston.
"The outstanding balance of the mortgage is compared to the
basis in house. If that produces a gain, it's a taxable
gain. If it's a nonrecourse mortgage, it's a capital gain."
That's right. Even though you aren't selling the house and
the bank is, the IRS views the transaction as if you were
the seller. That means you could owe taxes on the sale. The
bad news comes directly from the IRS, via
Publication 544:
"If you do not make payments you owe on a loan secured by
property, the lender may foreclose on the loan or repossess
the property. The foreclosure or repossession is treated as
a sale or exchange from which you may realize gain or loss.
This is true even if you voluntarily return the property to
the lender. ... You figure and report gain or loss from a
foreclosure or repossession in the same way as gain or loss
from a sale or exchange. The gain or loss is the difference
between your adjusted basis in the transferred property and
the amount realized."
Those calculations also take into consideration any
cancellation of debt income and the type of mortgage.
So yes, you could indeed pay tax on the money that was used
to pay back the mortgage even though you don't get any of
it.
Let's assume the example homeowner mentioned earlier has
nonrecourse mortgage debt of $110,000 and an adjusted basis
of $20,000 in the home, which has a fair market value of
$100,000. The owner has no ordinary tax liability for that
$10,000 difference in his debt and the home's value. But
when a nonrecourse mortgage is foreclosed and that debt is
greater than the home's value, the property is treated for
tax purposes as if it were sold for the balance of the
mortgage.
That means this homeowner would have a $90,000 difference
between the mortgage debt and his basis ($110,000 less
$20,000) and that $90,000 is taxable capital gain from the
"sale or other disposition" of the home. So even though the
foreclosed-upon owner didn't get any cash from the
transaction, he still owes taxes on what is known as phantom
income. The only good news is that the taxes are collected
at the lower 15 percent (or 5 percent for lower-income
taxpayers) capital gains rate.
If that same homeowner's mortgage was recourse debt and his
lender canceled the $10,000 difference between the
outstanding loan and the home's fair market value, the
foreclosed-upon owner would owe higher, ordinary taxes on
that forgiven 10 grand. In addition, his capital gains bill
would be based on $80,000 -- the property's fair market
value of $100,000 less his $20,000 adjusted basis.
For some struggling homeowners, the taxes on forgiven debt
or phantom income are all too real.
"If it's $10,000, that's a relatively small spread; $2,000
to $2,500 in federal and state taxes," says Lanzaro. "But
it's not just the working man having this problem.
Everybody's getting in over their head these days.
"If you have a $700,000 mortgage and the bank can only get
$500,000 in a foreclosure sale, now you're talking about
some tax liability."
And don't think the IRS won't find out. The agency has a
mechanism to catch foreclosure sales. The lender is supposed
to issue a
1099-C to alert the
former homeowner and IRS of the canceled debt and, in
certain cases, a
1099-A showing the
information you need to figure your gain or loss.
"Some people are moving and the 1099 has trouble catching
up," says Gary Garwitz, tax partner with BKD LLP in
Springfield, Mo. "If you're in that situation and had a
mortgage you didn't pay off, make sure you get that 1099."
The IRS definitely will get its copy and expect the
associated taxes. If they're not paid, penalties and
interest will be added.
Home-sale exclusion opportunity
There is one bit of good news for our hypothetical homeowner
and others dealing with foreclosure-induced taxes. You can
get out from under at least part of the IRS bill if you meet
the homeownership tax-exclusion rules.
This popular tax break allows a single homeowner who sells
his property under more favorable circumstances to exclude
up $250,000 profit from taxes; the exclusion is $500,000 for
married couples filing jointly.
The exclusion also applies in foreclosures. As long as the
"seller," in this case the foreclosed-upon owner, lived in
the home as his principal residence for two of the last five
years, he also can avoid taxes on any capital gain profit,
phantom or real.
Bankruptcy and insolvency solutions
Two other circumstances offer tax relief in foreclosures,
but both could cause other financial problems.
If a homeowner can show he's insolvent before the discharge
of the mortgage and turnover of the property, as well as
afterward, any proceeds are not taxed. However, says
Trenholm, "insolvency is a little tricky. There's no strict
definition of what assets (go in the calculation), but for
the most part, a lot of people caught in the real estate
crunch can establish that condition."
The other option is bankruptcy.
"Forgiveness debts, in these cases, are not taxed," says
Roth. "They don't want the bank chasing them down, which is
why many times people going through foreclosure also go
through bankruptcy."
However, filing for bankruptcy has its own set of
considerations. "New bankruptcy rules don't give (filers) a
lot of relief," says William S. Bost, a member of the
Raleigh, N.C.-based law firm Ragsdale Liggett PLLC. "If you
have a job and are making money, the new bankruptcy rules
don't give you a whole lot of help. It gives you some time,
but I don't think that's necessarily the way to go.
"It used to be like going to church, you walk in and walk
out absolved, but it's not like that anymore," says Bost.
"Now, it's not worth the pain you pay the rest of your
life."
One thing lending and tax experts all agree on: If you're
facing foreclosure, take action as soon as you realize
you're in trouble. And get professional help to determine
exactly what your personal tax labiality might be in the
transaction.
Lanzaro has two other recommendations: "The best advice is,
don't buy a house you can't afford, and don't get an
adjustable-rate mortgage."
Other options
If you're stuck with more house than you can pay for, there
are a couple of options in addition to foreclosure. Either
is likely to reduce the stress of this terrible time and
probably will do a little less damage to your credit report.
Each, however, still has tax and other potential long-term
financial implications.
Short sale:
This real-estate transaction has become popular among
homeowners who are having problems making payments on a
mortgage that is more than their house is worth. Rather than
waiting for the bank to foreclose, the owner works with the
lender to complete a sale of the home for less than the loan
balance.
"You have a property you're just trying to get out from
under," says Paul Haarman, vice president of Renaissance
Mortgage in Salem, N.H. "Everybody is all lined up at the
table and the buyer buys the property and the lender agrees
to the price. You have a $250,000 debt, the bank nets only
$220,000 and that $30,000 is written as a foreclosure
shortage."
A short sale keeps a foreclosure from showing up in your
credit record, but the shortfall will appear there as a
delinquent loan. It's not as bad as a foreclosure, but, says
Bost, "It's on the credit report and, as a (future) borrower
and consumer, it will haunt you."
Deed-in-lieu of foreclosure:
In this case, says Trenholm, the homeowner basically says to
the lender, "I want to save you some time, some money. How
about I just turn over the property?"
This way the foreclosure process is avoided, which will help
the borrower, because it won't show up on a credit record.
However, it could still show up on a credit report as
forgiven debt.
This process has "pretty much the same tax consequences as a
foreclosure," says Trenholm. Because you are being relieved
of the indebtedness on the property, for tax purposes it's
still considered sale of the property.
"All it does is make it a little bit easier to go through
the process," he says.
Tax liabilities remain
The argument for short sales and deeds-in-lieu is that they
are beneficial to strapped borrowers. From a tax and
financial perspective, however, they don't really matter.
"All of these situations are basically the same," says
Stein. "The mechanics and timing may be a little different,
but essentially in all of them at some point a lender is
saying to the borrower you don't have to pay the rest of
what you owe. When he tells the borrower that, that's
cancellation of indebtedness income."
"The only benefit," says Bost, "is the 'It's over' factor."
Freelance writer Kay Bell writes Bankrate's tax stories from
her home in Austin, Texas, and blogs daily on tax topics at
Don't Mess with Taxes.
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