Foreclosure Tax Basics
A foreclosure transaction occurs when a mortgage lender repossesses a borrower’s property and then sells it to pay off the debt. In most cases, however, a foreclosure will only happen when the mortgage debt exceeds the property's fair market value, or FMV. In this situation, the federal income tax rules treat the foreclosure as a sale for the FMV amount.
Therefore, a tax gain will result if the property’s FMV exceeds its tax basis. (The tax basis of a principal residence usually equals the original cost of the property, plus the cost of any improvements.) On the other hand, a tax loss will result if the property’s FMV is less than the tax basis.
If a mortgage lender also forgives some or all of the debt against your property in conjunction with or after the foreclosure transaction, you have cancellation of debt (COD) income. That income is taxable unless an exception applies.
Remember: Just because your property is foreclosed doesn’t necessarily mean the lender will forgive any of the unpaid mortgage balance (the so-called deficiency). When there is no forgiveness, there is no COD income. That said, mortgage lenders in these tough economic times sometimes will forgive all or part of the deficiency, so COD income can be fairly common these days.
Don't Forget the Home Sale Gain Exclusion Break
Another thing to consider is whether or not you qualify for the federal home sale gain exclusion break, which allows an unmarried person to exclude (pay no tax on) a gain of up to $250,000 while married joint filers can exclude up to a $500,000 gain. To qualify, you generally must have: (1) owned the home for at least two years during the five-year period ending on the foreclosure date and (2) used the home as your principal residence for at least two years during the five-year period ending on that date.
The Bottom Line
Probably the most important thing to understand about a principal residence foreclosure is that the mortgage lender will not necessarily forgive any of the unpaid balance that remains after the property is sold. However, in the current environment, some forgiveness would not be unusual. Also, keep in mind that you may not know for quite a while after the foreclosure whether anything will be forgiven.
Tax-wise, the most important thing to understand is that a foreclosure can potentially result in a taxable gain, and it might result in some taxable COD income, too.
Fortunately, with a principal residence foreclosure, an otherwise-taxable gain can often be excluded for federal purposes thanks to the home sale gain exclusion break (state income tax results can vary). Also, some or all of the COD income may be tax-free thanks to favorable tax-law exceptions. However when no exception applies, the COD income is fully taxable.
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