Debt Forgiveness
What happens after the mortgage on your house is foreclosed? You don’t have the debt, but you MAY have the tax liability. There are two main areas of concern:
1. Income from cancellation of debt
2. Gain on sale of the foreclosed property
Let’s discused the first one:
There are two types of loans: recourse and non-recourse. Recourse loans are the ones for which the borrower is personally liable (i.e. the mortgage company tries and may be able collect from you even AFTER the house is foreclosed). Non-recourse loans are the ones which are only secured by the property foreclosed. In CA, if you used the borrowed funds to purchase the principal residence (under 4 units), your loan is non-recourse. If you refinanced after the purchase, it will become recourse (in most cases). You need to check your loan documents to verify the type of the loan if you refinanced the property after your purchase.
After you figured out the type of your loan, you can determine if there is cancellation of debt. Generally, there will be no cancellation of debt on non-recourse loans. Different story with recourse loans. Most likely, cancellation of those loans will result in cancellation of debt income. There are exceptions which allow you to exclude that income (insolvency, bankruptcy, qualified rental/farm real estate indebtedness etc.), but they result in the unpleasant consequence of decreasing your basis in the property (up to the amount of the excluded debt, but not below zero).
The second step is to determine the gain (or loss) on sale of your property. Foreclosure is considered sale for tax purposes, so it is possible to end up having a capital gain on sale of property, which must be included in income, unless you have some capital losses to offset it or you can claim the principal residence exclusion ($500,000 for married filing jointly/$250,000 for married filing separate).
In the case of principal residence, the loss will not be deductible. But could be deductible with rentals, which will happen rarely since most rental real estate debt is recourse, the basis will be reduced to zero and the foreclosure will end up being considered a sale at a gain.
Pretty complex stuff, and every situation is unique. Don’t try to save a few dollars, ask a tax practicioner (and a reputable one) for help.
1 comment April 19th, 2010
