09/25/07: If Your Home Is Foreclosed, You May Have To Pay Tax
By Benny L. Kass
Foreclosures are up, and many families are losing their home. That's bad enough, but the Internal Revenue and the Tax Code has a surprise for you: you may have to report income and capital gains tax, even though you will not receive any money.
The concept is called "debt cancellation". Section 61 (a) of the Tax Code specifically states that "gross income means all income from whatever source derived, including (12) income from discharge of indebtedness..."
Most homeowners are completely unaware of this obscure provision. They usually consider that such matters apply to corporations and high-income individuals, but unfortunately the law applies to all taxpayers, regardless of income.
There are two different taxes that may be assessed against you: ordinary income and capital gains tax.
Let's look at this example:
You bought your home a couple of years ago for $170,000. Earlier this year, when your house was worth approximately $200,000, your lender foreclosed. Because you did not make mortgage payments for some time, your mortgage had increased to $220,000.
The IRS wants you to subtract the fair market value from the amount of your debt. This comes to $20,000 ($220,000 - 200,000).
Unless you qualify for an exclusion (discussed below) this $20,000 is taxable income and must be included on your Form 1040 next year.
But that's not the end of the analysis. You then have to subtract your adjusted basis from the fair market value of the house. In our example, that is $30,000 (200,000 - 170,000). It should be noted that this analysis is the same as if you had sold your house for $200,000. If you have owned and lived in the house for at least two years before the foreclosure, you can exclude up to $250,000 of this profit - or up to $500,000 if you are married and file a joint tax return. Otherwise, the $30,000 is considered profit and you will have to pay capital gains tax to the IRS and possibly to the State in which you live.
There are, however, two exclusions, which may be of assistance: when the discharge occurs in a title 11 bankruptcy case or if the discharge occurs when the taxpayer is insolvent, you will not have to pay money if you lose your house by way of a foreclosure.
In our example, if at the time of the foreclosure you had other debts - such as credit cards or car loans - which exceed your assets, you are considered "insolvent" and will not have to pay any tax. According to the IRS, you should "determine your liabilities and the fair market value of your assets immediately before the cancellation of your debt to determine whether or not you are insolvent and the amount by which you are insolvent." (IRS Publication 908, Bankruptcy Tax Guide).
If your home is foreclosed, your lender must sent you a year-end statement (Form 1099-C). This form will show you the amount of debt forgiven and the fair market value of the property at the time of the foreclosure.
You should review this form carefully. The value that your lender places on your property is critical. As discussed above, the income tax you may have to pay is based on the difference between that value and the amount of your mortgage at the time of the foreclosure. So if you believe your home has been undervalued, make sure that you obtain independent appraisals from real estate brokers or from your local government assessor. If the form contains errors, get in touch with your lender. If they agree with you, they will send you a corrected Form.
This is a highly complex and specialized area of tax law. Recognizing this, the Internal Revenue Service just announced that they have "unveiled a special new section today on IRS.gov for people who have lost their homes due to foreclosure." (IR-2007-159, dated September 17, 2007).
Well, its not yet a section on their web-site. According to a spokesperson in the Public Affairs Section of the IRS, to date there is currently only one item there. However, that material is quite helpful and should be read by every homeowner who is in debt, It is entitled "Questions and Answers on Home Foreclosure and Debt Cancellation". (www.irs.gov/newsroom/article/0).
Foreclosure should be the last resort. If you are in debt, and start missing your monthly mortgage payments, don't ignore this. You should immediately talk with your lender and see what options are available to you. Keep in mind that legitimate lenders do not want to foreclose on you home. Especially in todays market, where home sales are weak, the lender does not want to add your house to the rest of their inventory (called "Real Estate Owned" or REO).
Additionally, the jurisdiction in which you live may have set up programs to give temporary relief for delinquent homeowners.
And perhaps the most important thing to do is to consult with your financial advisors, who can assist you in determining whether you will have to pay any tax should you ultimately lose your house.