Losing a home to foreclosure is already a harrowing experience. As though that is not bad enough, home foreclosure can also have negative tax consequences. This is because debt settlement is considered income by the Internal Revenue Service (IRS) or relevant tax authority. The only thing left to debate is whether the ‘income’ is taxable or non-taxable. It is no foregone conclusion that one would face negative tax consequence, especially with the enactment of the Mortgage Forgiveness Debt Relief Act back in 2007. However, in some cases there might be little or no relief on debt relief.
♦ Debt income
At first, it might seem odd that a home foreclosure might be treated as income if the debt is cancelled. However, consider that the lender cannot retrieve funds issued. Assuming that there are no exemptions, a forgiven debt can yield a hefty tax liability – as much as $200 – $400 per $1000, depending on your tax bracket.
♦ Mortgage Forgiveness Debt Relief Act (2007)
To stem the economic crisis facing homeowners and lenders at the time, the Mortgage Forgiveness Debt Relief Act was passed in 2007. Typically, debt forgiveness must be counted as income, since the taxpayer received money without having to repay. According to the IRS, this Act allows taxpayers to exclude the amount of debt forgiven from a mortgage on their principal residence. This Act covers foreclosure on a principal residence as well. The caveat is that the foreclosure must have arisen from the decline in the home’s value or the taxpayer’s financial condition. Home equity loans used for purposes other than home improvement would not be covered either. In addition, this Act is only in force until 2012.
♦ Debt cancellation on non-recourse loans
In the context of home foreclosure, the most significant aspect of this section is the one on non-recourse loans. In many cases of home foreclosure, the property is held as collateral. Therefore, the lender can only repossess the property in the event of foreclosure. According to the IRS, home foreclosure can result in tax consequences from taxable cancellation or in the event of a reportable gain.
♦ When debt income is non-taxable
The taxpayer’s situation and/or the reason for the debt discharge also dictate whether any debt relief from a home foreclosure is taxable or not. If the debt is discharged because of bankruptcy proceedings, the income is considered non-taxable. Related to bankruptcy is the concept of insolvency, although the two are distinct. Insolvency occurs when the sum of your debts is greater than the sum of your assets. The complexity and inherent nature of this suggests that any cancelled debt from your home foreclosure may or may not be taxable.
♦ Taxable cancellation and tax gains
The main tax consequences of home foreclosures are taxable cancellation of debt and tax gain resulting from it. A taxable cancellation is the difference between the total amount still owned on the home and the fair market value of the property. The tax gain is then calculated by subtracting the adjusted basis of the property (purchase price plus cost of renovations) from the fair market value of the home. For more information on this, check the Tax Guy.
♦ Losses on foreclosure
Since gains or debt forgiveness count as debt income, it is logical to think that losses on a home foreclosure might be deductible as an expense. However, this is far from the truth. Losses from a foreclosure are not tax deductible.
Some home foreclosures are more complicated than others are. It is also important to recognize the exclusions based on your situation. A taxpayer can have no tax liability, partial liability or full liability depending on the circumstances. It might be prudent to consult with a tax professional in determining the nature of this.