The Tax Consequences of Foreclosure
Foreclosure Can Trigger Capital Gains and Canceled Debt Income Taxes
The Internal Revenue Service treats a foreclosure the same as the sale of a property. It once was yours and you no longer own it, so you could end up paying taxes on a foreclosed property. The event can trigger a capital gain and, in some cases, you might also owe income tax on any portion of the mortgage debt that might have 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 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.
There's no mutually agreed-upon sales price in a foreclosure situation and without escrow statements, 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 depends on whether your mortgage was a recourse or a non-recourse loan.
Both these figures are reported to you and to the IRS by the lending institution in box 2 (outstanding loan balance) or box 4 (fair market value) of the 2021 Form 1099-A, "Acquisition or Abandonment of Secured Property."
You're personally responsible for the mortgage debt if you had a recourse loan. 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, or
- The fair market value of the property being foreclosed
You can have canceled debt income from the foreclosure with this type of loan as well, in addition to a capital gain.
Mortgages used to acquire homes are typically non-recourse loans, while refinanced loans and home equity loans tend to be recourse loans. This isn't an absolute rule, however. It can also depend on the laws of the state in which you reside.
A non-recourse loan is one where the borrower isn't personally liable for repayment of the loan. 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 in this case is the outstanding loan balance immediately before the foreclosure. 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 with a non-recourse loan, either, because the lender is prohibited by law from pursuing you for repayment.
You'll Receive Tax Reporting Documents
You'll receive one of two tax forms after foreclosure, or perhaps both:
- 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 gain related to the property.
- Form 1099-C is issued by the bank after the bank has canceled or forgiven a debt on a recourse loan. This form will indicate how much of the debt was canceled. You might receive only a single Form 1099-C that reports both the foreclosure and the cancellation of debt, or you might receive 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
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 $250,000 or even $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.
Single taxpayers can exclude up to $250,000 in capital gains, and married taxpayers filing joint returns can double that amount.
You can still qualify for an exclusion from capital gains tax under the modified rules for calculating your gain or loss if the foreclosed property was mixed-use—it was your primary residence at one time and a secondary residence at another time. The rules are also relaxed somewhat for members of the Armed Forces.
Capital Gains Tax Rates
As of tax year 2020, the tax return you'd file in 2021, 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 $40,000
- 15% if taxable income is from $40,001 to $441,450
- 20% if taxable income is more than $441,450
Heads of Household
- 0% if taxable income is under $53,600
- 15% if taxable income is from $53,601 to $469,050
- 20% if taxable income is more than $469,050
Married Filing Jointly and Qualifying Widow(er)s
- 0% if taxable income is under $80,000
- 15% if taxable income is from $80,001 to $496,600
- 20% if taxable income is more than $496,600
These long-term capital gains income parameters are different from those that were in place before 2018. Rates were tied to ordinary income tax brackets before the Tax Cuts and Jobs Act (TCJA) went into effect. The TCJA assigned long-term capital gains 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.
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. Discharged debt was included in taxable income prior to 2007.
Discharged debt was again considered to be taxable income by the IRS when the MFDRA expired at the end of 2017, but this provision of the tax code was reinstated for foreclosures that occur from January 1, 2018 through December 31, 2020. 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 don't have to concern yourself with paying income tax on debt discharged through foreclosure through the end of 2020 and if your forgiven debt doesn't exceed $2 million.