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If you thought a foreclosure ended the
financial miseries associated with your
former home, think again. You soon could
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 longtime 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.
Forgiven 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 loan amount. Or
when the lender forecloses on the
property and sells it for less than the
outstanding mortgage.
In both instances, the difference for
which the borrower is no longer
responsible is 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% to 35% and depend upon
your income.
"People who advise you to walk away talk
about payment consequences, not the tax
consequences," says Frederick M. Stein,
RIA senior analyst from Thomson Tax &
Accounting. "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."
How much and what type of tax the IRS
expects after a foreclosure depends in
large part on whether the loan is
"recourse" or "nonrecourse."
With a recourse loan, the debtor is
personally liable for the debt. In a
foreclosure, if proceeds from the home
sale don't cover the outstanding
mortgage, the debtor must pay the
difference. This includes interest that
accrues during the foreclosure process.
Nonrecourse debt is secured by the loan
collateral. If money from the sale of
the property doesn't cover the
outstanding debt, the lender has no
legal ability to get the additional
funds from the debtor.
A sale is a sale is a sale
But with either type of loan, 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, MST (master's degree in taxation)
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."
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."
The calculations take into consideration
any cancellation-of-debt income and the
type of mortgage. Here's an example:
Let's say a homeowner has nonrecourse
mortgage debt of $110,000 and $20,000
equity, or "adjusted basis," in the
home, which has a fair market value of
$100,000. The owner has no ordinary tax
liability for that $10,000 difference
between his debt and the home's value.
But what about the $90,000 difference
between the mortgage debt and his basis
in the house ($110,000 less $20,000)?
That is seen as 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% (or
5% for lower-income taxpayers)
capital-gains rate.
If that same homeowner's mortgage was
recourse debt and his lender forgave the
$10,000 difference between the
outstanding loan and the home's fair
market value, the foreclosed-upon owner
would owe ordinary taxes on the 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.
"If it's $10,000, that's a relatively
small spread; $2,000 to $2,500 in
federal and state taxes," says Ted
Lanzaro, CPA and owner of an accounting
firm in Shelton, Conn.
"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."
And don't think the IRS won't find out.
The agency has a mechanism to catch
foreclosure sales. The lender is
supposed to issue a
1099-C to alert the former homeowner
and IRS of the canceled debt and, in
certain cases, a
1099-A showing the information you
need to figure your gain or loss.
"Some people are moving and the 1099 has
trouble catching up," says Gary Garwitz,
tax partner with BKD in Springfield, Mo.
"If you're in that situation and had a
mortgage you didn't pay off, make sure
you get that 1099."
The IRS definitely will get its copy and
expect the associated taxes. If the
taxes aren't paid, penalties and
interest will be added.
"The IRS is far more tenacious than most
banks," says tax analyst Roth. "Their
responsibility is to collect the tax on
the income you have."
Home-sale exclusion still applies
There 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.
This popular tax break allows a single
homeowner who sells his property under
the usual circumstances to exclude up to
$250,000 profit from taxes; the
exclusion is $500,000 for married
couples filing jointly.
The exclusion also applies in
foreclosures. As long as the "seller,"
in this case the foreclosed-upon owner,
lived in the home as his principal
residence for two of the past five
years, he can avoid taxes on any
capital-gain profit, phantom or real.
Bankruptcy and insolvency solutions
Two other circumstances offer tax relief
in foreclosures, but both could cause
other financial problems.
If a homeowner can show he's insolvent
before the discharge of the mortgage and
turnover of the property, as well as
afterward, proceeds are not taxed.
However, says CPA Trenholm, "insolvency
is a little tricky. There's no strict
definition of what assets (go in the
calculation), but for the most part, a
lot of people caught in the real-estate
crunch can establish that condition."
The other option is bankruptcy.
"Forgiveness debts, in these cases, are
not taxed," says Roth. "They don't want
the bank chasing them down, which is why
many times people going through
foreclosure also go through bankruptcy."
However, filing for bankruptcy has its
own set of considerations. "New
bankruptcy rules don't give (filers) a
lot of relief," says William S. Bost, a
member of the Raleigh, N.C., law firm Ragsdale Liggett. "If you have
a job and are making money, the new
bankruptcy rules don't give you a whole
lot of help. It gives you some time, but
I don't think that's necessarily the way
to go.
"It used to be like going to church --
you walk in and walk out absolved -- but
it's not like that anymore," says Bost.
"Now, it's not worth the pain you pay
the rest of your life."
One thing lending and tax experts all
agree on: If you're facing foreclosure,
take action as soon as you realize
you're in trouble. And get professional
help to determine exactly what your
personal tax liability might be in the
transaction.
Lanzaro has two other recommendations:
"The best advice is, don't buy a house
you can't afford, and don't get an
adjustable-rate mortgage."
Other options
If you're stuck with more house than you
can pay for, you have a couple of
options in addition to foreclosure.
Either is likely to reduce the stress of
this terrible time and probably will do
a little less damage to your credit
report.
Each, however, still has tax and other
potential long-term financial
implications.
Short sale: This
real-estate transaction has become
popular among homeowners who are having
problems making payments on a mortgage
that is more than their house is worth.
Rather than waiting for the bank to
foreclose, the owner works with the
lender to complete a sale of the home
for less than the loan balance.
"You have a property you're just trying
to get out from under," says Paul
Haarman, vice president of Renaissance
Mortgage in Salem, N.H.
"Everybody is all lined up at the table
and the buyer buys the property and the
lender agrees to the price. You have a
$250,000 debt, the bank nets only
$220,000 and that $30,000 is written as
a foreclosure shortage."Â
A short sale keeps a foreclosure from
showing up in your credit record, but
the shortfall will appear there as a
delinquent loan. It's not as bad as a
foreclosure, but, says Bost, "It's on
the credit report and, as a (future)
borrower and consumer, it will haunt
you."
Deed-in-lieu of foreclosure:
In this case, says Trenholm, the
homeowner basically says to the lender,
"I want to save you some time, some
money. How about I just turn over the
property?"
This way the foreclosure process is
avoided, which will help the borrower,
because it won't show up on a credit
record. However, it could still show up
on a credit report as forgiven debt.
This process has "pretty much the same
tax consequences as a foreclosure," says
Trenholm. Because you are being relieved
of the indebtedness on the property, for
tax purposes it's still considered sale
of the property.
"All it does is make it a little bit
easier to go through the process," he
says.
Tax liabilities remain
The argument for short sales and
deeds-in-lieu is that they are
beneficial to strapped borrowers. From a
tax and financial perspective, however,
they don't really matter.
"All of these situations are basically
the same," says Stein. "The mechanics
and timing may be a little different,
but essentially in all of them at some
point a lender is saying to the borrower
you don't have to pay the rest of what
you owe. When he tells the borrower
that, that's
cancellation-of-indebtedness income."
"The only benefit," says Bost, "is the
'It's over' factor."
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