If you thought a bank foreclosure ended the financial
miseries associated with your former home, think again. You could
soon be hearing from the IRS about taxes due in connection with
the residence you no longer own.
"You can walk away from the big house payment,
but not from the potential tax implications," says John W. Roth, senior tax
analyst at CCH in Riverwoods, Ill. "And if you couldn't afford the mortgage,
you probably can't afford the taxes."
As the lending
crisis continues to shake out, more homeowners, particularly those who used creative
mortgages to buy their houses, could be in this predicament. Even long-time homeowners
who refinanced their properties based on increased value when the real estate
market was hot could find themselves in tax trouble if they lose their properties
to the bank.
The issue is complicated by many factors. There
are, of course, the financial problems that have led to the foreclosure process.
Add to that the loan terms (some of which employed those creative mortgage products),
the housing market in your area and, of course, federal tax laws, and you've got
a recipe for financial disaster.
||Foreclosure and taxes
but not forgotten
In many cases, the tax problem associated with
a foreclosure arises from a seemingly benevolent
move -- the lender forgives some
of the loan. This happens when a lender and a
borrower negotiate a reduction in the loan amount.
It also happens when the lender forecloses on
the property and sells it for less than the outstanding
In both instances,
the difference for which the borrower is no longer responsible is usually considered
cancellation of debt, or COD income. It also is called discharge of indebtedness
income or discharge of debt. Regardless of the name, under the tax code, it's
all taxable income. The tax on COD is calculated at ordinary rates, which range
from 10 percent to 35 percent depending upon your income.
the tax law essentially does is treat the foreclosure as a sale by the debtor,
the owner of the property, with the proceeds being paid to the lender," says
Frederick M. Stein, RIA senior analyst from Thomson Tax & Accounting. "And
any debt owed above and beyond those proceeds is cancellation of indebtedness
That's why financially struggling homeowners
who are considering turning over the house keys to the bank should think twice.
While sending the lender "jingle mail," a term coined to describe the
sound of a key-containing envelope, will get you out from under the burden of
the monthly house payment, it won't prevent a tax bill in your mailbox.
who advise you to walk away talk about payment consequences, not the tax consequences,"
says Stein. "If they owe $50,000 and $10,000 is forgiven, they think of it
as a gift. It may be a gift from the lender, but not from the IRS."
adds, "The IRS is far more tenacious than most banks. Their responsibility
is to collect the tax on the income you have."
type of mortgage matters
Just how much and what type of tax the IRS
expects after a foreclosure depends in large part on whether the loan is of the
recourse or nonrecourse variety.
With a recourse loan, the
debtor is personally liable for the debt. In a foreclosure, it means if the property
sale proceeds are not enough to cover the outstanding mortgage, the debtor must
pay the difference. This includes interest that accrues during the foreclosure
A nonrecourse debt, however, is secured by the loan
collateral. If money from sale of the property doesn't cover the outstanding debt,
the lender has no legal ability to get the additional funds from the debtor.