A few years ago, investors loved foreclosures: it was an opportunity to buy cheap. Today, investors themselves are getting foreclosed on. As always, the IRS is making things worse. Whether you are buying foreclosures or being foreclosed – you need to know the IRS rules.
1. Foreclosure is a sale.
You give up the house, and you receive something in return. What do you receive? Relief from the mortgage. If you owe $150,000 on your mortgage, and the bank forecloses – the bank essentially “buys” the property from you for $150,000. Tax consequences are similar to a normal sale: if you originally paid $130,000 for this house – you have a capital gain of $20,000; if you paid $170,000 – you have a capital loss of $20,000.
Unfortunately, it gets more complicated.
2. Recourse or non-recourse?
A critical issue is to find out whether your mortgage is a “recourse” or “non-recourse” debt. Let’s assume that this house on which you owe $150,000 is worth $145,000. If the bank forecloses and sells your house, they will get only $145,000. However, you owed them $150,000 – so you are still $5,000 short. Can your bank demand this $5,000 from you and sue you? If you have a “recourse” loan – the answer is yes. If you have a “non-recourse” loan – the answer is no.
I used to think that most residential mortgages were recourse, and most commercial loans were non-recourse. It turns out that the situation is way more complicated, especially when you have second mortgages, refinances, and out-of-state properties. The only way to know for sure is to ask a good real estate attorney.
Why do you care? First, you need to know whether your lender can bother you after the foreclosure, demanding more money and possibly obtaining a judgment against you. Second, it matters for the IRS.
3. Gain with a non-recourse loan
Let’s return to our example. You bought the house for $130,000, and you now owe $150,000 on your refinanced mortgage. At foreclosure, you “receive” a paper profit of $20,000. The question is: what kind of gain is it, for tax purposes? If your loan is non-recourse, the answer is simple: $20,000 capital gain. How much the property is worth – does not matter.
4. Gain with a recourse loan
Not so if you have a recourse loan. Now we have to consider current market value of the property. In our example, it was worth $145,000. The IRS now says that your capital gain is the difference between $145,000 and $130,000 that you paid for the property – or $15,000.
In addition, you have another $5,000 of income: the difference between $145,000 market value of the property and $150,000 balance on the cancelled mortgage. This $5,000 is not capital gain, it is “forgiveness of debt” income – taxed at “ordinary” income tax rates, same as apply to salary income.
Just like with non-recourse loans, you have total income of $20,000. However, only $15,000 of that will be taxed as capital gain (low rate), and the other $5,000 will be taxed as ordinary income (high rate). Not good.
5. What if it is a loss?
Let’s slightly modify our example. As before, you owe $150,000 on a house that is worth $145,000. You originally paid $170,000 for this property.
With non-recourse loan, you have a $20,000 loss: $170,000 cost minus $150,000 debt relief. With recourse loan, the result may sound crazy: you will have $25,000 of capital loss ($170,000 minus $145,000), and you will also have $5,000 of “debt cancellation” income ($150,000 minus $145,000), potentially taxed at high ordinary rate.
6. Do I have to pay if it was my own house?
Chances are – no. As we discussed, you may have two types of income related to a foreclosure: capital gain and cancellation of debt. Capital gain on the sale of primary residence is usually tax-free, whether it is a foreclosure or a normal sale. Of course, some conditions apply, so check with your real estate accountant.
Cancellation of debt on primary residences (but not second homes or vacation homes!) became tax-free under December 2007 law.
Again, there is some small print. The new law does not cover “cash-out” refinances. In our first example, you paid $130,000 for the house and later refinanced, so you end up owing $150,000 on a property worth $145,000. With a recourse loan, you will have a $5,000 “debt cancellation” income, but it will NOT be tax-free under the new law, because of “cash-out” refinancing. In contrast, “rate-down” refinancing is no problem.
Please note that recourse loans can trigger “debt cancellation” income even if you have an overall loss. On your personal residence, capital losses are not deductible, however this phantom debt cancellation income may still be taxable! If you think it’s messed up, I agree. Send your complaints to Washington, D.C.
7. Do I have to pay if it is an investment property?
Maybe. If you have a capital gain from foreclosure, it will be taxable just like a normal sale. If you have a capital loss, it will be deductible, subject to the usual annual limit of $3,000.
The most troubling issue is depreciation recapture. If this was a rental property, you have been saving on taxes by depreciating it. Since foreclosure is a sale, all this prior depreciation becomes taxable. As a result, you may have a capital gain even if your defaulted mortgage was less than what you paid for the property. To add insult to injury, this nasty “depreciation recapture” is taxed at a higher rate than capital gain.
8. Can I avoid taxes on “debt cancellation” income?
Yes – if you’re in bankruptcy or considered “insolvent.” Despite the derogatory word, it does not mean that you have to sleep under Loop 610 overpass. Insolvent means that your total debts exceed your total assets. In other words, if you sell everything you have, you still will not be able to pay all your debts.
There is a good chance that a person who is dealing with foreclosure will qualify as “insolvent” under the IRS definition. If you do – then your “debt cancellation” income is not taxable, whether it is from your own home or from investment properties. You will only need to attach an extra form to your tax return to explain your situation.
However, even if you are not insolvent, you may still be off the hook. I already mentioned that the new 2007 law provides a relief from “debt cancellation” income on foreclosed primary residences. What about that phantom income on investment properties? Believe it or not, there is a little-known rule called Qualified Real Property Business Indebtedness. Under this rule, most of your debt cancellation income can avoid taxes – as long as you do not do a “cash-out” refinance.
9. Where do I get all these numbers for the IRS calculations?
Your lender should send you one or both of these forms: 1099-A (Abandonment of Secured Property) and/or 1099-C (Cancellation of Debt). When you receive the forms, look at the box titled “Fair market value of property.” This number does not come from comps. It should be either current appraised value of the property or the foreclosure bid price. Make sure that this market value is reasonable. You may have to argue with the lender to get the number corrected.
10. Are there more rules?
You kidding me? Of course, there are more rules, and many of them make no sense. What else is new? We are talking IRS here.
How can you learn about them? The starting point may be the IRS website. Download Publication 4681 If this is not enough or too confusing – find a real estate accountant. We accountants speak the IRS language – so we can translate.