THE loss of our homes to foreclosure, short sale, or deed in lieu of foreclosure is akin to adding insult to injury – after losing our homes, we also have to worry about lender repercussion, credit history, and tax consequences. Let’s define and discuss tax consequences of foreclosure, short sale, and deed in lieu of foreclosures.
Definitions
Foreclosure: Foreclosure is an involuntary process whereby a lender repossesses property that was pledged as collateral for a mortgage loan. Foreclosure can occur judicially (court action) or non-judicially (trustee sale).
Short Sale: A short sale occurs when an owner sells property for less than the debt owed on a property. The lender must consent to the sale and agree to accept less than the full loan amount and release the property from the mortgage lien.
Deed in Lieu of Foreclosure: A deed in lieu of foreclosure occurs when an owner conveys property to the existing lender in exchange for cancellation of the mortgage loan (“in lieu” of a foreclosure by the lender).
Tax Consequences of Foreclosures, Short Sales, and Deeds in Lieu
Each of the above circumstances results in two potential taxable consequences to the owner:
1. Tax on capital gain and/or
2. Tax on cancelled/forgiven debt.
Whether we get hit by one or two of these taxes depend on whether the debt is recourse or non-recourse.
Tax Consequences If Debt Is Recourse (Personal Liability to Borrower):
There are two tax consequences:
1. Capital gain – the difference between the adjusted basis and the fair market value. You are taxed at the applicable capital gains rate of either 5% or 15% depending on your tax bracket.
2. Debt Relief – the difference between the debt and the fair market value. Cancellation or forgiveness of debt is taxed as ordinary income.
For example, you bought an apartment building for $400,000 with a loan of $350,000 many moons ago. The property appreciated in value to $1 million so you obtained a second loan of $850,000. Total outstanding loan balance is $1.2 million. Let’s assume that the adjusted basis is $0 after you have fully depreciated the building. The two tax consequences if you have recourse loans are:
1. Capital gain must be recognized on the difference between the fair market value of the property ($1 million) and the adjusted basis ($0). Hence, you must pay capital gains tax on the $1 million.
2. Debt Relief must also be recognized on the difference between the fair market value ($1 million) and the debt ($1.2 million). You must pay ordinary income tax on the $200,000 cancelled debt at regular tax rates.
Tax Consequences If Debt Is Non-Recourse (Borrower Not Personally Liable):
1. Capital gains: This is the only tax consequence. Capital gain is the excess of your loans over your adjusted basis. In this case, it’s the same difference between the fair market value of the property ($1 million) and the adjusted basis ($0).
2. Debt Relief: There is no tax on cancellation or forgiveness of debt for non-recourse loans.
In summary:
1. If the debt is recourse, you pay capital gains tax and ordinary income tax.
2. If the debt is non-recourse, you pay capital gains only.
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Victor Santos Sy graduated Cum Laude from UE with a BBA and from Indiana State University with an MBA. Vic worked with SyCip, Gorres, Velayo (SGV – Andersen Consulting) and Ernst & Young before establishing Sy Accountancy Corporation in Pasadena, California.
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He has 50 years of experience in defending taxpayers audited by the IRS, FTB, EDD, BOE and other governmental agencies. He is publishing a book on his expertise – “HOW TO AVOID OR SURVIVE IRS AUDITS.” Our readers may inquire about the book or email tax questions at [email protected].