Tax Impact of Home Foreclosure

A recent report indicates there were more than one million home foreclosures in 2010, and that’s the good news. The bad news is it is widely anticipated that another million or more homes will be repossessed in 2011. A key question facing these former homeowners is just how does the foreclosure impact their federal taxes? Right now, you are probably thinking how in the world can taxable income and a federal tax liability result from a home foreclosure? Keep reading for the answer to this puzzling question.

Before 2007, any part of a mortgage forgiven after a foreclosure (such as when the house was sold and the bank forgave a mortgage exceeding the home’s sale price) was cancellation of debt (COD) income, which is considered taxable. Fortunately, tax law changes in the 2007 Mortgage Relief Act (as extended) saved the day—at least for foreclosures occurring before 2013.
The help comes in a special provision called the qualified principal residence indebtedness exclusion. Up to $2 million of COD income can be excluded under this provision. To qualify, the COD transaction must occur before 2013; the cancelled debt must have been originally incurred to acquire, construct, or improve the taxpayer’s principal residence; and the debt must be secured by that residence.

The taxpayer’s basis (generally what was paid for the house, plus the cost of any improvements) in the residence is reduced, but not below zero, by the amount excluded under this exception. Thus any excluded COD will decrease any loss (or increase any gain) on the sale of the residence. However, this usually doesn’t matter since the loss is not deductible, and any gain up to $250,000 ($500,000 if married) generally qualifies for the home-sale exclusion and isn’t taxable anyway.

Example: Dealing with COD income on a foreclosed house.

Several years ago, Tim and Tina paid $500,000 for their home. Thanks to a terrible real estate market, their home is now worth $350,000, but their mortgage balance is $450,000. To make matters worse, Tim has lost his job. With no way to make their monthly payments and no hope of selling their home for enough to pay off their mortgage, Tim and Tina hand the deed to the bank and walk away from their mortgage. The bank subsequently nets $350,000 from the sale of the home and forgives the remaining $100,000 loan balance. As far as Tim and Tina are concerned, they’ve done nothing but lose their home and all the money they put into it.

For federal tax purposes, however, two things have happened—they’ve sold their home for a $150,000 loss and realized COD income of $100,000—and the two transactions do not offset each other. In fact, the loss from the sale of their residence is never deductible, whereas the COD income is fully taxable unless an exception applies. Fortunately for Tim and Tina, they can exclude the $100,000 of COD income under the qualified principal residence indebtedness exclusion previously mentioned. This will decrease the basis in their home by $100,000. Their loss will now be $50,000 instead of $150,000, but it’s not deductible anyway. The bottom line is that the foreclosure has no impact on their federal income taxes.

Unfortunately, the special COD exclusion does not apply to all home loans. It doesn’t work for second mortgages or home equity loans that were used for purposes other than to improve the taxpayer’s principal residence, nor does it work for vacation home mortgages. It will only help those who borrowed too much to acquire, build, or improve a principal residence.