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Special section Fighting foreclosure

Losing your home in a foreclosure is bad enough. Wait until you get the tax bill.

Double whammy: Foreclosure and taxes

Double whammy: Foreclosure and taxes
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"In nonrecourse situations, you have a house, the mortgage and the market value of whatever the bank can sell it for and put toward the outstanding loan," says Ted Lanzaro, CPA and owner of his own accounting firm in Shelton, Conn. "If the house is worth $100,000 and there is a $110,000 loan on it, the bank in a nonrecourse situation cannot go after the borrower for that $10,000 difference."

Cancellation of debt income and its tax implications typically come into play with recourse loans. If the house's fair market sales price is less than the unpaid mortgage and the lender forgives the remaining mortgage debt, that amount is taxable income at ordinary tax rates.

With either type of mortgage, a foreclosed-upon homeowner could end up owing capital gains taxes without ever receiving any money from the foreclosure sale.

A sale is a sale is a sale
"foreclosure is not a sale in normal terms, but it is still treated under tax code as a sale," says Stephen Trenholm, CPA and tax manager at Rucci Bardaro & Barrett in Boston.

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"The outstanding balance of the mortgage is compared to the basis in house. If that produces a gain, it's a taxable gain. If it's a nonrecourse mortgage, it's a capital gain."

That's right. Even though you aren't selling the house and the bank is, the IRS views the transaction as if you were the seller. That means you could owe taxes on the sale. The bad news comes directly from the IRS, via Publication 544:

"If you do not make payments you owe on a loan secured by property, the lender may foreclose on the loan or repossess the property. The foreclosure or repossession is treated as a sale or exchange from which you may realize gain or loss. This is true even if you voluntarily return the property to the lender. ... You figure and report gain or loss from a foreclosure or repossession in the same way as gain or loss from a sale or exchange. The gain or loss is the difference between your adjusted basis in the transferred property and the amount realized."

Those calculations also take into consideration any cancellation of debt income and the type of mortgage.

So yes, you could indeed pay tax on the money that was used to pay back the mortgage even though you don't get any of it.

Let's assume the example homeowner mentioned earlier has nonrecourse mortgage debt of $110,000 and an adjusted basis of $20,000 in the home, which has a fair market value of $100,000. The owner has no ordinary tax liability for that $10,000 difference in his debt and the home's value. But when a nonrecourse mortgage is foreclosed and that debt is greater than the home's value, the property is treated for tax purposes as if it were sold for the balance of the mortgage.

That means this homeowner would have a $90,000 difference between the mortgage debt and his basis ($110,000 less $20,000) and that $90,000 is taxable capital gain from the "sale or other disposition" of the home. So even though the foreclosed-upon owner didn't get any cash from the transaction, he still owes taxes on what is known as phantom income. The only good news is that the taxes are collected at the lower 15 percent (or 5 percent for lower-income taxpayers) capital gains rate.

If that same homeowner's mortgage was recourse debt and his lender canceled the $10,000 difference between the outstanding loan and the home's fair market value, the foreclosed-upon owner would owe higher, ordinary taxes on that forgiven 10 grand. In addition, his capital gains bill would be based on $80,000 -- the property's fair market value of $100,000, less his $20,000 adjusted basis.

-- Updated: Oct. 25, 2007
 
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