Abandonment and Foreclosure

Foreclosure rates remain at an unprecedented high level.  It is highly likely that you, the reader, know someone who has either lost a home to foreclosure or is struggling to avoid foreclosure.  It is even more likely you know someone who is “upside down” in their mortgage (owing substantially more than their home is worth) and debating whether to continue paying the mortgage or abandon the home. 

The continued frequency of foreclosure and the number of inquiries our office receives regarding it has impressed upon me the importance revisiting the tax consequences of foreclosure – of losing or walking away from your residence - including instances in which the owner abandons the home and the bank later forecloses or takes possession. 

But first, a word of warning: This is a highly complex area of the tax code.  Do not use this article as a basis for making decisions regarding your property or as guide to planning or preparing your taxes.  If you have experienced foreclosure, are facing foreclosure, or if you are considering abandoning your home please call our office or consult with another qualified tax professional.  Consulting with an experienced attorney may also prove to be a long-run, money-saving investment.

When a primary residence is foreclosed upon it can create two potentially taxable events.  First, the foreclosed home is, in effect, being sold to its creditors.  This sale may result in taxable capital gain or nondeductible loss (losses on personal-use property, such as a personal residence, are not tax deductible).  Second, foreclosure may also result in taxable income, if any portion of the mortgage is forgiven (unless a specific exception applies).  This income is called Cancellation of Debt Income

The sales price used to calculate gain or loss on a foreclosed home will depend on whether the property’s mortgage is “recourse” or “nonrecourse.”  Recourse loans are loans the borrower remains personally liable for after foreclosure.  Thus, if the bank takes a home and the mortgage is recourse, the owner remains personally responsible for the loan and any portion remaining after the home is sold by the bank.  Generally, refinanced mortgages, second mortgages and home equity loans are recourse loans.  For recourse loans, the “sales price” is the lesser of the loan amount or the fair market value of the property. 

If the mortgage is nonrecourse, then the borrower is not responsible for the loan after foreclosure. The mortgage used to originally purchase the property is usually a nonrecourse loan. If the loan is nonrecourse, then the “sales price” is the value of the loan. 

Once “sales price” is determined, the capital gain or loss is calculated by subtracting the owner’s investment, called the owners “basis,” from the sales price.  Generally, the owner’s investment (basis) includes (but is not limited to) original purchase price plus capital improvements (such as additions, etc.).  If the difference between sales price and basis is positive, there is capital gain; if negative, a capital loss.  If there is a capital gain and the owner lived in the property two of the past five years, they may be able to exclude all or a portion of the gain from income.  A capital loss on personal-use property is not tax deductible.

Cancellation of debt income can occur when the amount of recourse debt exceeds the fair market value (or sales price if the property is sold) of the home and the bank forgives the remaining debt.  This debt will be taxed as ordinary income unless an exemption applies.  These exemptions include (but are not limited to) debts discharged in bankruptcy, insolvency immediately before the debt was forgiven, and Qualified Principal Residence Indebtedness.  The Bankruptcy exclusion is fairly straight forward.  Proving insolvency, however, requires additional calculations.  Qualified Principle Residence Indebtedness applies only to the portion of the debt that was used to acquire, construct or substantially improve your principle residence.  Any debt forgiven that was not used to purchase, build or improve your home will be considered taxable cancellation of debt income unless another exemption applies.

As you can see, there many complex tax issues involved here.  Use this introduction as an overview so you can talk to your tax professional with more confidence.