The type of mortgage mattersJust how much and what type of tax the IRS expects after a foreclosure also 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 process.
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.
"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.
But now, under the 2007 law, homeowners with recourse loans also can avoid associated tax liability.
A sale is a sale is a saleWith either type of mortgage, a foreclosed-upon homeowner could end up owing capital gains taxes without ever receiving any money from the foreclosure 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.
"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."
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.
For some struggling homeowners, the taxes on forgiven debt or phantom income are all too real, prompting the temporary law change late last year.
"If it's $10,000, that's a relatively small spread; $2,000 to $2,500 in federal and state taxes," says Lanzaro. "But it's not just the working man having this problem. Everybody's getting in over their head these days. If you have a $700,000 mortgage and the bank can only get $500,000 in a foreclosure sale, now you're talking about some tax liability."
Home-sale exclusion opportunityThere is one bit of good news for our hypothetical homeowner and others dealing with foreclosure-induced taxes. You can get out from under at least part of the IRS bill if you meet the homeownership tax-exclusion rules.