Tax Ramifications to Foreclosure

2009 had a high rate of individuals losing their homes to foreclosure and to make matters worse there are tax ramifications to foreclosure. One would think it was bad enough to lose your home to foreclosure but there is more bad news. Even though you did not sell your home the IRS views the transaction as a sale. You can have a short sale, where the sale price is less than the outstanding mortgage or you can have a foreclosure, where the lender forces the sale of your home and the proceeds are turned over to the lender. If in either case the lender does not pursue you for the balance due it is possible for the cancellation of the debt to result in two forms of taxation. The first form is the gain or loss from the deemed sale of the home. Even though you did not sell your home and receive proceeds from the sale the IRS treats the transaction as if you did sell your home and depending on what you paid for your house (your basis) you could have gain. Fortunately this type gain qualifies for the home sale exclusion. So if you are married filing jointly you can exclude up to $500,000 of this gain.
The second form of taxation is on the debt forgiveness. The IRS views the balance of your loan that the lender did not make you pay as income. Let’s say you purchased your home for $350,000 and had to borrow that same amount. Your loan is now at $330,000 but your home is only worth $300,000. If the bank sells your home and applies the proceeds to your loan, you still owe them $30,000. If they do not make you pay back that $30,000 it is as if they “gave” you the $30,000. The IRS calls that “gift” income and you pay tax on it. Thankfully there is relief. The debt relief provision expires in 2012 but until then for married filing joint taxpayers up to $2 million in debt relief on a main home can be excluded.
This relief only applies to the debt incurred to acquire the home. So if you refinanced your home and wrapped the purchase of a new car into the loan or paid off your credit card debt with the loan the only amount that qualifies for the relief is the amount for the home, but it still is a pretty good deal.
There is a special form you need to fill out and send to the IRS in the year that you had income from the debt relief caused by a foreclosure, but otherwise the process is painless. I for one am hoping that 2010 has less home foreclosures!