Most of the foreclosure consequences depend on the circumstances. The most important variable in determining the federal income tax consequences of a principal residence foreclosure is:

What is the value of the property in comparison to the mortgage balance?

Here are some possible scenarios that may apply.

Property Worth Less than Loan Balance

When the property’s fair market value (FMV) is less than the mortgage balance (which is the most common situation in foreclosure), the tax rules treat the foreclosure as a sale of the property for the FMV amount. Yet- the foreclosure could trigger a tax gain if the FMV of the home exceeds the cost basis (basis usually equals the purchase price plus the cost of improvements).

However, if the FMV is greater than the cost basis, that gain will often be free from federal income taxes thanks to the principal residence gain exclusion. Under the exclusion, unmarried homeowners can exclude (pay no tax on) gains of up to $250,000. Married joint-filing couples can exclude gains of up to $500,000.

To qualify for the tax exclusion, you generally must have:

• Owned the home for at least two years during the five-year period ending on the foreclosure date; and
• Used the home as your principal residence for at least two years during that five-year period.

If the cost basis of a principal residence exceeds FMV, the foreclosure transaction will trigger a nondeductible loss.

If the lender then forgives part of or all of the deficiency (the difference between the mortgage debt and the foreclosure sales proceeds), the forgiven amount constitutes cancellation of debt (COD) income for tax purposes. Any COD income must be reported as income on your Form 1040 for the year the debt forgiveness occurs. For a short time, there are temporary provisions in the tax code for principle residences and you may qualify for a tax-law exception on the debt cancellation income.

Property Worth More Than Loan Balance

When the property’s FMV exceeds the loan balance (a less-common situation), the foreclosure is treated for federal income tax purposes as a sale of the property for a price equal to the loan balance plus any additional proceeds received by the borrower as a result of the foreclosure sale. The cost basis is the same as outlined above.

Summary of Recourse Loans

An important thing to understand about a mortgage foreclosure is that the lender can still come after a borrower for any deficiency/shortage that remains after the foreclosure sale. The foreclosure doesn’t automatically cancel the debt. It will often take many months or even several years for a lender to decide whether to pursue a borrower for the full deficiency, or to forgive part of it, or to forgive the whole thing.

In summary, the important factors are that a principal residence mortgage foreclosure can result in a gain and maybe some COD income too. Thankfully, any gain will often be free from federal income taxes thanks to the principal residence gain exclusion (State tax results may vary). Some or all of any COD income may also be tax free thanks to beneficial tax-law exceptions. When no exception applies, COD income must be reported as income on a borrower’s tax return for the year the debt forgiveness occurs.

As you can see, the tax consequences of a foreclosure are complex. Please contact Norman LeBlanc, CPA any member of our Tax Services Team if you have any questions about your situation.