The Tax Consequences of a Foreclosed Home
Foreclosure can trigger capital gains and canceled debt income
As far as the Internal Revenue Service is concerned, a foreclosure is the same as the sale of a property. The bottom line is that it once was yours and now it's not. This means the event can trigger a capital gain or loss, and if any part of the mortgage debt is forgiven or cancelled, income tax may be due on that amount as well.
Capital Gain or Loss on Foreclosures
The sale of real property normally goes through an escrow process and the seller receives statements showing how much the home was sold for.
With foreclosures, however, there is no escrow. The lending bank simply takes possession of the house. The property has changed hands so the IRS says a foreclosure is still considered a sale, or in more technical terms, a "disposition" of property.
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 profit a person made, or how much money was lost on the transaction. In a foreclosure situation and without escrow statements, the selling price used for tax purposes isn't immediately clear. 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 or the outstanding loan balance immediately prior to the foreclosure, depending on the type of loan you had. Both these figures will be reported to you and to the IRS by the lending institution on Form 1099-A.
Recourse or Non-Recourse Loans
Your mortgage was either a recourse or a non-recourse loan. Mortgages used to acquire a house 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.
If you had a recourse loan, you're personally liable for the debt and the lender can pursue you for repayment even after the property has been repossessed. In this case, the figure used as the sales price when calculating your capital gain or loss 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
You may have canceled debt income from the foreclosure with this type of loan.
A non-recourse loan is one where the borrower is not personally liable for repayment of the loan. In other words, the loan is satisfied and the lender cannot pursue the borrower for further repayment after it repossesses the property. For non-recourse loans, the figure used as the sales price is the outstanding loan balance immediately before the foreclosure. The IRS says you are effectively selling the house back to the lender for full consideration of the outstanding debt. You will not have any canceled debt income because the lender is prohibited by law from pursuing you for repayment.
Reporting a Capital Gain or Loss
After you've determined what type of loan you had on your property, you can determine the sales price.
- The home was your primary residence.
- You lived in it for at least two of the last five.
Individual taxpayers can exclude $250,000, and married taxpayers filing jointly can double that amount.
Some additional rules apply. If the foreclosed property was mixed-use—it was your primary residence at one time and a secondary residence at another time—you may still qualify for an exclusion from capital gains tax under the modified rules for calculating your gain or loss.
As of 2017, the tax rate on long-term capital gains for properties, those owned a year or longer, is 15 percent for taxpayers who fall in the 25 through 35 percent tax brackets.
The rate is 20 percent for those who fall into the 39.6 tax bracket. Homeowners who fall into the 10 or 15 percent tax bracket may not have to pay a capital gains tax at all. If you owned your home for less than a year, you must pay capital gains tax at the same rate applied to your regular income—in other words, according to your tax bracket.
If the foreclosed property was a rental property, report the sale on Form 4797.
The Mortgage Forgiveness Debt Relief Act
Foreclosures can trigger taxable income besides capital gains. If the lender forgives or cancels the mortgage debt on a recourse loan, you might have to include this as income, but there are a few exceptions that can exclude canceled debts from tax treatment.
The most important of these is the exclusion for debt secured by your main home. Under the Mortgage Forgiveness Debt Relief Act, canceled debts of up to $2 million can be excluded as long as the debt was used to buy or build your principal residence. This tax exclusion technically expired at the end of 2016, but it still covers debts that are forgiven in 2017 if a written agreement was entered into in 2016. And Congress reopened the issue in January 2017, so it's possible that the Act will ultimately be extended into future years.
Tax Reporting Documents Form 1099-A and Form 1099-C
Form 1099-A is issued by the bank after real estate has been foreclosed. It reports the 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 income related to the foreclosure.
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. If a lender both forecloses on a home and cancels the unpaid debt in the same year, you may 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.