To Foreclose or Not to Foreclose: Let’s Talk Taxes (Part 2)

Where Angels Fear to Tread

It was one of the hardest decisions you had to make.

In your mind, okay, I will let go of the house.  I cannot pay it anymore.  It makes no sense to pay for a steep mortgage when the value of the house has gone down by half.  No sense.  Everybody is doing it anyway.  I should be fine.

You do it, sign the papers, let the bank foreclose and rest on your laurels.

Then while sitting on the living room of your new rented apartment, you get a bill, a huge tax bill because – guess what – you have made money on the foreclosure of your home.  Money?  But where is it?

And then you find out that it is not so simple after all.  Foreclosures have tax consequences and these consequences (what you will pay, if any) will differ on whether you have a recourse or non-recourse loan. 

Huh? (we will be going a little technical here, please bear with me)

A recourse loan means that you are personally liable for the debt (they – the bank – can go after you for the last cent). 

A non-recourse loan means the debt is secured by the property and the debtor is not liable for the balance (if house is sold for less than the amount of the mortgage, you will not owe anything).  Most loans are non-recourse but here is a caveat: you have to read your mortgage papers to find out (or even consult an attorney).

To continue… (again, a little technical but I will be providing you with links)

In foreclosure, there are gains (I know it is hard to imagine). The tax is on the gains.

RECOURSE LOAN – house is sold at fair market value

Say the debt is $500,000 and the house is sold at fair market value at $450,000, there is a “gain” of $50,000 which is taxed as ordinary income (you would have to declare it on your income tax return) UNLESS it falls under a “qualified principal residence indebtedness” exclusion, which will allow you to have it excluded from taxable income.  In California, only debts canceled until 2009 (2007 to 2009, I think) are eligible.  For federal, it was extended until 2012.

NON-RECOURSE LOAN –  house is sold for balance of the mortgage

Say the balance on the mortgage of your house is $500,000 and the tax basis is $300,000 (value of house at purchase plus improvements – tax basis is used to compute the tax gain or tax loss), your gain is $200,000 (although you did not see or feel it).  You will have to pay for that gain (again, declare it on your income tax return) UNLESS it is a gain for “foreclosure of principal residence” and you meet the holding requirements (vary from state to state), in which case you can be eligible for an exclusion (in California ceiling for “gain for foreclosure of principal residence” is $250,000, if filing joint with spouse and property jointly owned).

Yes, you will always have to pay on your foreclosure gains unless you know your rights (or the tax laws) and apply the exclusions at the right time.

You say… “But… but… but… I actually have no gains.  Didn’t you understand that the house is cheaper now than when I bought it?  I am selling at a loss!”

Okay, I hear you.  Sadly, though, whatever “losses” you perceive to have had, you cannot deduct it on your tax returns (it is a non-deductible personal loss).  No can do.  It is simply not done, because the loss is not recognized.

Friends, know your rights, know your laws, know the consequences, ask and then ask again until you think you understand.  Because it is important that you do.  Sometimes, the few hours that you spend on this would mean saving thousands of dollars (and stopping an aneurism).

I am rooting for you.

Be rich,

Issa

Article by Issa. Glass Painting by D. Copyright 2010.
Website: www.YouWantToBeRich.com
Email: issa@youwanttoberich.com

Disclaimer: I encourage you to seek a competent professional, like an accountant or a lawyer specializing in foreclosures.  I specifically disclaim any liability, loss, or risk which is incurred as a consequence, directly or indirectly, of the use and application of any of the contents of this article.

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