If you, like many, lost your primary home or other property to foreclosure in 2010 when the payments became unaffordable, watch out. You could be on the hook for income taxes.
How can that be? When you take out a mortgage, you receive money, but it isn't taxed as income. That's because you are obligated to repay it. But if you receive loan proceeds and then your obligation to repay them goes away, the amount you received and aren't obligated to repay becomes income and is therefore taxable.
Of course, with the tax code, there are many exceptions. Here's a simplified version that covers many foreclosure situations.
Foreclosure of a primary residence
In general, if you lose your primary residence to foreclosure, a taxable event has not occurred. That's because the Mortgage Forgiveness Debt Relief Act of 2007 grants relief to those who lost homes during the housing crisis. It applies to foreclosures occurring from 2007 through 2012. It also applies to principal reductions achieved through a loan modification.
Under this law, up to $2 million of forgiven mortgage debt may be excluded--or up to $1 million if you're a single filer or married filing separately. Note that the exclusion doesn't apply "in cases where the reason for foreclosure is not directly related to a decline in the home's value or your financial condition."
Another caveat is that this exclusion only applies to debt used to "buy, build, or substantially improve" your home. Home equity financing for things like debt consolidation, college tuition, boats or other uses is not covered under the exclusion.
Here's an example of a primary residence debt cancellation that is taxable
In 2002, James bought a home for $200,000 and took out a mortgage for $160,000. In 2006, the home had appreciated to $250,000, and he took out an interest-only home equity loan for $20,000. There was no amortization of the second mortgage because he did not make principal payments.
By 2010, when his mortgage lenders foreclosed, James' first mortgage balance was $140,000. The cancellation of the $140,000 was excluded from taxes, but the $20,000 second mortgage balance was not.
Reducing your home's basis by the amount of your exclusion
If you exclude debt cancellation income from tax and continue to own your primary residence (as would be the case if you got a loan modification), your home's basis must be reduced by the amount of your exclusion.
This means that if your Home Affordable Modification Program (HAMP) modification gets you a $20,000 principal reduction, that amount will be added to your gain when you eventually sell your home and may be taxed.
Foreclosure of investment property or vacation home
In the event that your lender forecloses on your investment property or vacation home, your lender will likely send you form 1099-C, Income from Cancellation of Debt. But even if you don't get the dreaded form, you have to report the income unless:
- The debt was included in a bankruptcy filing (in which case, attach IRS Form 982);
- You were insolvent to an extent greater than the amount of your taxable gain at the time of foreclosure (meaning your liabilities exceeded your assets by more than you gained from the foreclosure; use IRS Form 982);
- The foreclosed property is a "qualified farm," meaning that 50 percent of your gross receipts come from the farm;
- The foreclosed property was used in a trade or business.
Determining your taxable income from foreclosure
How you go about calculating your taxable income from foreclosure depends on whether the mortgage is a non-recourse loan (meaning that the lender must take back the property as full satisfaction for the debt) or a recourse loan (meaning the lender can sue you for any shortfall after the foreclosure sale).
If your mortgage is a recourse loan, here's how you calculate cancellation of debt income (skip this step if your mortgage is a non-recourse loan):
- Take the total amount of the debt immediately prior to the foreclosure;
- Subtract the fair market value of the property (if you get a 1099-C, this amount is in box 7);
- Any amount over zero is taxable income and you enter it on line 21 of your 1040.
Next, determine your gain from foreclosure:
- Take the fair market value of the property foreclosed. For non-recourse loans, enter the amount of the debt immediately prior to the foreclosure
- Subtract your adjusted basis in the property (usually this is your purchase price plus the cost of any major improvements minus accumulated depreciation on rental property)
- Report any amount greater than zero on your Schedule D, titled "Capital Gains and Losses."
Here's an example of a taxable foreclosure
Debra owned a rental home that she paid $200,000 for. Her mortgage lender foreclosed on the home in 2010. At the time the mortgage lender took the home back, she still owed $175,000 on the property, but it was only worth $110,000. Her income from the cancellation of the debt is the difference, or $65,000. This amount is reported as "other income" on her IRS Form 1040 and taxed at her ordinary rate.
Debra's basis in the property equals the $200,000 she paid for it, less the $30,000 in depreciation she has deducted over the years. Taking the $110,000 fair market value and subtracting her $170,000 basis results in a negative number, so there is no gain to be reported on her Schedule D.
Get professional help
A foreclosure can quickly turn your taxes into tricky business. Your best bet in the event that you receive a 1099-C or lose investment or vacation property to foreclosure is to find a good tax professional, or at least a good tax software program.