The Tax Consequences of Foreclosure
Foreclosure Can Trigger Capital Gains and Canceled Debt Income Taxes
As far as the Internal Revenue Service is concerned, a foreclosure is treated the same as the sale of a property. The bottom line is that once it was yours and now you no longer own it. The event can trigger a capital gain and, in some cases, you might also owe income tax on the amount of any part of the mortgage debt that's been forgiven or canceled.
Capital Gains on Foreclosures
The sale of real property normally goes through an escrow process. The seller receives statements showing how much the home was sold for. There's no escrow period with foreclosures, however. The lending bank simply takes possession of the home.
The IRS says that a foreclosure is still considered a sale—or in more technical terms, a "disposition of property"—because the property has changed hands.
The basic formula for calculating capital gains is to subtract the basis or cost of the property from the sales price. The difference is how much of a profit the seller made, or how much money was lost in the transaction.
In a foreclosure situation and without escrow statements, there's no mutually agreed-upon sales price, but there's still a "sales price" for tax purposes. It will be either the fair market value of the property as of the date of the foreclosure, or the outstanding loan balance immediately prior to the foreclosure. It will depend on the type of mortgage loan you had. Your mortgage was either a recourse or a non-recourse loan.
Both these figures will be reported to you and to the IRS by the lending institution in boxes 2 and 4 of Form 1099-A.
If you had a recourse loan, this means that you're personally responsible for the debt. The lender can pursue you for repayment even after the property has been repossessed—it has "recourse."
In this case, the figure used as the sales price when calculating any potential capital gain is the lesser of the following two amounts:
- The outstanding loan balance immediately before the foreclosure minus any debt for which the borrower remains personally liable after the foreclosure
- The fair market value of the property being foreclosed
In addition to a capital gain, you can have canceled debt income from the foreclosure with this type of loan as well.
Mortgages used to acquire homes tend to be non-recourse loans, while refinanced loans and home equity loans tend to be recourse loans. This is by no means an absolute rule, however. It can also depend on the state in which you reside.
A non-recourse loan is one where the borrower isn't personally liable for repayment of the loan. In other words, the loan is considered satisfied and the lender can't pursue the borrower for further repayment if and when it repossesses the property.
The figure used as the sales price is the outstanding loan balance immediately before the foreclosure of a non-recourse loan. The IRS takes the position that you're effectively selling the house back to the lender for full consideration of the outstanding debt, so there's generally no capital gain.
You won't have any canceled debt income, either, because the lender is prohibited by law from pursuing you for repayment.
You'll Receive Tax Reporting Documents
- Form 1099-A is issued by the bank after real estate has been foreclosed upon. This form reports the date of the foreclosure, the fair market value of the property, and the outstanding loan balance immediately prior to the foreclosure. You'll need this information when you're reporting any capital gains related to the property.
- Form 1099-C is issued by the bank after the bank has canceled or forgiven any debt on a recourse loan. This form will indicate how much debt was canceled. You might receive only a single Form 1099-C that reports both the foreclosure and the cancellation of debt instead of receiving both a 1099-A and a 1099-C if your lender both forecloses on the home and cancels the unpaid debt in the same year.
Reporting a Capital Gain or Loss
You can determine the sales price after you've determined what type of loan you had on your property. Report the foreclosure on Schedule D and Form 8949 if the foreclosed property was your primary residence. You might qualify to exclude up to $500,000 of gain from taxation subject to certain rules:
- The home was your primary residence.
- You owned the home for at least two of the last five years (730 days) up to the date of sale.
- You lived in the home for at least two of the past five years ending on the date of foreclosure.
Individual taxpayers can exclude up to $250,000 in gains, and married taxpayers filing jointly can double that amount.
If the foreclosed property was mixed-use—it was your primary residence at one time and a secondary residence at another time—you can still qualify for an exclusion from capital gains tax under the modified rules for calculating your gain or loss. The rules are also relaxed somewhat for members of the armed forces.
Capital Gains Tax Rates
As of tax year 2019, the rate on long-term capital gains for properties owned one year or longer depends on your overall taxable income and filing status.
- 0% if taxable income is under $39,375
- 15% if taxable income is from $39,375 to $434,550
- 20% if taxable income is over $434,550
Heads of household:
- 0% if taxable income is under $52,750
- 15% if taxable income is from $52,750 to $461,700
- 20% if taxable income is over $461,700
Married Filing Jointly and Qualifying Widow(er)s:
- 0% if taxable income is under $78,750
- 15% if taxable income is from $78,750 to $488,850
- 20% if taxable income is over $488,850
These long-term capital gains income parameters are different from those that were in place in 2017. Rates were tied to ordinary income tax brackets before the Tax Cuts and Jobs Act (TCJA) went into effect. The TCJA assigned them their own brackets.
It's a short-term capital gain if you owned your home for less than a year. You must pay capital gains tax at the same rate that's applied to your regular income—in other words, according to your tax bracket.
Report the sale on Form 4797 if the foreclosed property was a rental property. Special rules apply.
When Discharged Debt Is Taxable Income
The Mortgage Forgiveness Debt Relief Act of 2007 (MFDRA) provided that taxpayers could exclude from their taxable incomes up to $2 million in discharged mortgage debt due to foreclosure—a nice tax break indeed. Prior to 2007, discharged debt was included in taxable income.
Then the MFDRA expired at the end of 2017, so discharged debt was once again considered to be taxable income by the IRS. Fortunately, this provision of the tax code is back again, at least for foreclosures that occur from Jan. 1, 2018 through Dec. 31, 2020. Title I, Subtitle A, Section 101 of the Further Consolidation Appropriations Act of 2020, signed into law by President Trump in December 2019, extends this provision through the end of 2020.
You no longer have to concern yourself with paying income tax on debt discharged through foreclosure, at least through the end of 2020 and if your forgiven debt doesn't exceed $2 million.
Internal Revenue Service. "Form 1099-A Acquisition or Abandonment of Secured Property," Page 2. Accessed Jan. 13, 2020.
Internal Revenue Service. "Publication 523 (2018), Selling Your Home." Accessed Jan. 13, 2020.
Internal Revenue Service. "Topic No. 409 Capital Gains and Losses." Accessed Jan. 13, 2020.
Internal Revenue Service. "Home Foreclosure and Debt Cancellation." Accessed Jan. 13, 2020.
Congress.gov. "H.R. 1865—Further Consolidated Appropriations Act, 2020." Accessed Jan. 13, 2020.