The Tax Implications And Consequences Of Residential Foreclosures

By Ashley Henshaw. May 7th 2016

Foreclosure is a tough enough issue to deal with, so don’t make it harder by ignoring the possible tax consequences of this process. Going through a foreclosure usually means that your finances are already stretched pretty thin, so it’s important to know what to expect come tax time.

The Tax Consequences Of Foreclosure

There are several tax issues that must be dealt with once a foreclosure has been completed. Not all of the tax consequences of this process will apply to every homeowner going through a foreclosure, but it’s important to know what the possible tax implications will be and how to deal with them. The following are some of the most common tax ramifications of foreclosure:

Taxable Income From Debt Cancellation: If your lender cancels or forgives the debt you owe on your lost property, the IRS views it as taxable income. This is usually documented on the IRS form 1099-C, which the lender typically sends the borrower at the end of the year. To use an example, if you owe $120,000 on your mortgage and your foreclosed home sold for $100,000, the lender might forgive that $20,000 difference but the IRS considers it to be taxable income. Since this income is taxed at ordinary rates, the amount can be substantial and potentially overwhelming for the homeowner.

Capital Gains From Foreclosure Profit: In some cases, a lender can make a profit on the sale of a foreclosed property. In this case, the IRS treats this profit as capital gain for the homeowner, despite the fact that the homeowner doesn’t actually receive this money. Although the taxes on this would be at a lower capital gains rate, it can still add up to a large amount for many homeowners. (For more information on how the capital gains tax works, see Understanding The Rules Of The Federal Capital Gains Tax.)

Possible Exceptions

It can be difficult to read about the possible tax consequences of foreclosure, particularly for those who believed this process would at least ease their financial burden. The good news is that there are some exceptions to the tax rules listed above which could exclude some homeowners from having to pay large tax bills as a result of a foreclosure.

The Debt Relief Act of 2007 may allow some homeowners to avoid listing their cancelled debt as taxable income. If the mortgage on the home was used to buy or improve your primary residence and the home was used as collateral on that mortgage, you may qualify for this exclusion. Unfortunately, this exception generally does not apply to foreclosed properties that were used as a second home or rental property. (For more information on the Debt Relief Act, see The Tax Implications Of The Mortgage Forgiveness Debt Relief Act.)

Similarly, there is another IRS stipulation in place that prevents individuals from having to pay taxes on profit made from the sale of their foreclosed property. If the profit comes from the sale of your main home, you are excluded from having this profit be considered as a capital gain. There are limitations to this tax break, however. Single homeowners can exclude up to $250,000 of profit from taxes; that amount increases to $500,000 for married couples filing jointly. In addition, the seller of the foreclosed property must have lived in the home as a primary residence for two of the last five years.

Certain homeowners may avoid taxes related to their debt forgiveness if their debt cancellation occurred after they declared bankruptcy. To qualify this exception, the homeowner must prove to the IRS that the debt forgiveness came after the person was declared bankrupt. The same rule applies if the homeowner became insolvent (their total debt was more than their total assets) before the debt forgiveness took place. However, it’s important to understand the full consequences of bankruptcy before considering going down this route if foreclosure appears to be imminent. (To learn more about bankruptcy, see 10 Common Myths About Declaring Consumer Bankruptcy.)

Keep in mind that the losses from the sale or foreclosure of your home cannot be claimed as a loss on your tax returns. Some individuals are under the impression that the money lost in the foreclosure of their home can be listed as a deduction on their taxes. Unfortunately this is not the case. In fact, it’s important to be aware that if the foreclosed home sells for less than the owed amount, the lender may be able to sue the borrower for the difference between the loan amount and the home’s sale price.

It’s important to accurately report any financial information relating to your foreclosure on your taxes. The IRS has several mechanisms in place to find out about this information, and failing to report it accurately could result in penalties and added interest. Talk to a professional tax expert if you have any concerns about the possible tax implications of your foreclosure. You can also speak with your lender if you need documentation or if you have questions about cancelled debt or the sale of your foreclosed property. The bottom line is that you need to do your homework ahead of time so you are not caught off-guard when tax season rolls around.

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