The Tax Consequences of Foreclosure: What You Need to Know
Foreclosure is a legal process whereby the lender takes possession of your property because you have failed to make the mortgage payments. Foreclosure proceedings can be initiated by the lender if you default on your mortgage for a certain period, typically three to six months.
Most people assume that foreclosure means just losing their home, but it also has significant tax consequences. The IRS (Internal Revenue Service) considers any forgiven debt as taxable income, and this includes debts discharged in foreclosure or short sales. In other words, if you owed $200,000 on your mortgage but only paid back $100,000 before the bank foreclosed and sold the house for less than what you owed ($150,000), then there is $50,000 in forgiven debt that will be considered taxable income.
The Mortgage Forgiveness Debt Relief Act
However, there is some good news for homeowners who are facing foreclosure or considering a short sale. In 2007 Congress passed The Mortgage Forgiveness Debt Relief Act which allowed taxpayers to exclude up to $2 million of forgiven debt from their taxable income when they lost their principal residence due to foreclosure or short sale.
This act was extended several times until it expired at the end of 2017. There is currently no legislation extending this relief beyond December 31st, 2020; therefore homeowners must understand how forgiveness of indebtedness affects them tax-wise going forward.
Tax Consequences Of Foreclosure
If your home goes into foreclosure and there is any deficiency balance left over after it’s sold at auction or through another means (short sale), this amount will likely be considered as “cancellation of debt” by the IRS.
Cancellation of Debt Income
Cancellation of Debt Income (CODI) refers to any canceled or forgiven debt that would otherwise need repayment by an individual taxpayer. CODI applies even though some part or all of such debt might have been secured against one’s assets like houses or cars.
For example, if you owe $300,000 on your mortgage but the bank forecloses and sells it for $250,000, there would be a deficiency balance of $50,000. This amount will be treated as CODI by the IRS. The lender may issue Form 1099-C to you or report it to the IRS.
Taxable Income
Since CODI is considered taxable income by the IRS, you must report it on your tax return in the year when the debt was discharged or forgiven. You might also need to attach Form 982 (Reduction of Tax Attributes Due to Discharge of Indebtedness) with your tax return.
Form 982 provides specific exemptions that taxpayers can use to reduce their taxable income from canceled debt. For example, if CODI is due to bankruptcy or insolvency, then some portion or all of it might not count towards taxable income.
Bankruptcy Exemption
If you declare bankruptcy before foreclosure proceedings begin and get a discharge for any mortgage-related debts included in your filing under Chapter 7 or Chapter 13 bankruptcy laws – then that’s an exemption from paying taxes on cancelled debt up until December 31st, 2025.
The Insolvency Exemption
If you are insolvent at the time when foreclosure happens (i.e., your total liabilities exceed assets), some part or all of CODI might not be taxed. To claim this exemption under insolvency rules on Form 982:
– Add up all your assets’ fair market value
– Subtract all liabilities owed immediately before cancellation
– If this result is negative (i.e., liabilities are greater than assets), then taxpayers qualify for exemption based upon insolvency
State Tax Consequences Of Foreclosure
While federal law governs taxation issues related to foreclosure and short sales across America; each state has its own laws regarding taxes after foreclosure sale proceeds have been distributed among various parties involved in these transactions like lenders, borrowers, and mortgage servicers.
Some states (such as California) follow the “One Action Rule,” which means that lenders can only recover one debt from a borrower. Therefore, if the bank forecloses on your home and sells it for less than what you owe on your mortgage, they cannot come after you for any deficiency balance left over after that sale.
Other states (such as Florida) follow the “Two-Action Rule,” which allows lenders to pursue both foreclosure proceedings against homeowners and seek a deficiency judgment in court to collect unpaid balances owed under their mortgages.
Conclusion
Foreclosure is a distressing process with significant tax consequences. If you are facing foreclosure or considering a short sale of your property, it’s essential to understand how these transactions will affect your tax liability. Remember that forgiven debts may be considered taxable income by the IRS and state law governs taxation issues related to foreclosure sales proceeds distribution among various parties involved in these transactions. Seek professional advice from qualified tax professionals when dealing with foreclosure-related issues or questions about taxes due following such events.