The Infernal Revenue Service. Those demons in suits can be quite good at kicking a person when they are down. One of the things not well understood by many people are the tax consequences of foreclosures.
A person has lost their home. They get booted out into the street; have their credit ransacked and destroyed for many years to come. After suffering all of these ignominies and defeats the IRS comes knocking for their share of the “profits”
♦ The IRS Viewpoint on Foreclosures
Bad things sometimes happen to good people, why would the IRS come after someone for being foreclosed on? Well the IRS doesn’t view it as punishment. It works like this: Banks must inform the IRS anytime they forgive significant debts. If someone is forgiven a 10,000 dollar debt, they now have 10,000 available that they didn’t have before.
♦ An Example of the Tax Consequences of Foreclosures
Let’s look at a concrete example. John Doe purchased a house for $250,000. He has been paying for years and has some equity in the house, but he still owes the bank $190,000. The bank forecloses and sells the house 120,000. The bank then writes off and “forgives” the remaining 70,000. Because of this John’s credit score is shot for many years to come. The thing is, since his loan was forgiven the IRS see’s John as having made $70,000 in profit, he owed that much money that he does not now owe.
When people do not understand this it can be very surprising to suddenly find a bill in the mail from the IRS.
♦ What can be done to mitigate the damage of foreclosures?
One action that is important to take is to get an appraisal of the home before foreclosure. This keeps the bank from setting the price “too low” just to get it off their books. If John’s house were appraised high and sold for 185,000 his obligation to the IRS would be minimal.
If the tax hit is high enough bankruptcy is always an option. It will crumble what little bit is left of your credit dignity, but will alleviate the difficulty. Taxes owed are not absolved through bankruptcy but perceived “gains” are so if you do not have the gain you do not have the tax. This is really an option of last resort, though. Certainly seek the financial assistance of a true expert LONG before it gets to this point.