Determining the Selling Price

The basic formula for capital gains is to subtract the basis or cost of the property from the selling price. In a foreclosure situation, the selling price used for tax purposes depends on whether the loan was a recourse or a non-recourse loan.

A recourse loan is a loan where the borrower is personally liable for the debt, and the lender can pursue repayment even after the property has been repossessed.

A non-recourse loan is a loan where the borrower is not personally liable for repayment of the loan; in other words, once the lender repossess the property used to secure the loan, the loan is satisfied and the lender cannot pursue the borrower for further repayment.

Mortgages used to acquire a house tend to be non-recourse loans, while refinanced loans and home equity loans tend to be recourse loans. How these loans are classified depends on state lending laws.

Determining Gain or Loss on a Foreclosure

For recourse loans, the figure used as the selling price is the lower of the following two amounts:

• the outstanding loan balance immediately before the foreclosure minus any debt for which the borrower remains personally liable after the foreclosure; or
• the fair market value of the property being foreclosed.

For non-recourse loans, the figure used as the selling price is the outstanding loan balance immediately before the foreclosure. You are considered as selling the house to the lender for full consideration of the outstanding debt.

Canceled Debt Issues

Another of foreclosure tax consequences is when foreclosures trigger taxable income besides capital gains. If the lender forgives or cancels the mortgage debt, that may need to be included as income unless an exception applies.

For recourse loans, the amount of debt canceled by the lender is potentially taxable income. There are a number of exceptions that exclude canceled debts from tax treatment. The most important of these is the exclusion for debt secured by your main home. Under the Mortgage Forgiveness Debt Relief Act, canceled debts of up to $2 million can be excluded as long as the debt was used to buy or build your principal residence. The Emergency Economic Stabilization Act extends this debt relief through 2012.

For non-recourse loans, there is no cancellation of debt income to be reported. That’s because the lender cannot pursue the borrower for repayment of the debt, even if the fair market value of the property is less than what was owed.

Foreclosure Tax Consequences for a Main Home

A main home is real estate used as the primary residence of the taxpayer. If a main home is foreclosed, the individual has available several exclusions to shield himself from taxes. First, any capital gains on a main home can be excluded, up to $500,000 for married couples or $250,000 for unmarred persons.

Second, if the mortgage loan was a non-recourse loan, the borrower would have no canceled debt income to report.

Third, if the mortgage loan was a recourse loan, the borrower can take exclude up to $2 million of canceled debts if the loan proceeds were used to buy or build a primary residence. Home equity loans can potentially be excluded from tax as well using the exclusion for insolvency.

Foreclosure Tax Consequences for Property Other than a Main Home

Second homes, vacation property, and rental properties can be foreclosed. Capital gains and canceled debt income are calculated in the same way. However, these properties do not qualify for the $2 million exclusion, nor do they qualify for the $250,000 capital gains exclusion; these two exclusions apply only to a main home.

Still, borrowers can shield themselves from foreclosure taxes by using the various exclusions for cancelled debts. In particular, it is likely that taxpayers will qualify for the insolvency exclusion.

Owners of rental property will want to take note of the depreciation recapture tax. This is a special type of capital gains tax based on the amount of depreciation deducted against the rental income.

In a nutshell, this article articulates the foreclosure tax consequences you need to think about when in a foreclosure situation.