The prospect of your losing your home can be stressful enough. You might be trying to figure out a way to catch up on the mortgage to avoid foreclosure, or maybe trying to find a new place to live. While you’re concentrating on important things like that, it’s easy to overlook the tax consequences for home foreclosures, which may come as an unpleasant surprise.

After the foreclosure is done, it’s possible to get a tax bill from the Internal Revenue Service (IRS). Whether you’ll get such a bill depends on a number of things, like:

Was your mortgage a recourse or non-recourse loan
Whether the foreclosure is treated as a sale of the property or the cancellation of a debt
Whether the Mortgage Forgiveness Debt Relief Act of 2007 (MFDRA) applies to you
Recourse or Non-Recourse
If your mortgage is a recourse loan, you’re personally responsible for repaying the bank or mortgage company. If you don’t repay the loan, or “default,” the bank can sue you for the remaining amount due on your loan if the proceeds from a foreclosure sale doesn’t cover the amount you owe.

On the other hand, if your mortgage is non-recourse, your lender can’t make you pay the loan. The only thing it can do is foreclose and sell your house for payment on the debt.

Sale
Regardless of whether your mortgage is recourse or non-recourse, the foreclosure is a taxable sale for you. This is true even if you give the lender a deed to your home in satisfaction of the debt, which is called a deed or transfer “in lieu of foreclosure.” Because the foreclosure is treated as a sale, you have to report any gain from the sale as income, and you’ll be taxed on that gain.

You don’t get a deduction for any loss that you might have as a result from the foreclosure.

Figuring a Gain
As with any other sale, you figure your gain from the foreclosure by taking the difference between the amount realized from the sale and the adjusted tax basis of the home. Usually, your adjusted tax basis equals the price you paid for the home plus the costs of major improvements. The amount realized generally equals the gross proceeds minus expenses. In a foreclosure the amount realized depends a lot on whether your loan is recourse or non-recourse:

For recourse loans, if your home is sold at a foreclosure sale, the amount realized is its fair market value, which is generally the sales price, minus expenses of the sale, such as court costs, legal fees and real estate commissions
For non-recourse loans, your amount realized equals the amount you owed on the mortgage plus any interest that comes due up to the time of the foreclosure
Cancellation of Debt
Generally, if you borrow money from banks or credit card companies, and the lender cancels or forgives that debt, the amount of debt that was cancelled is income for federal tax purposes. The cancelled debt is “money in your pocket” because it was loaned to you and you don’t have to repay it.

Until recently, the same logic applied to most recourse mortgages. After surviving the stress of foreclosure, many people were surprised by a tax bill from the IRS. Say at the time of foreclosure you still owe $200,000 on your mortgage, but according to the bank’s appraisal, the fair market value of the home is only $190,000. If you transfer the house to your bank in lieu of foreclosure and the bank doesn’t make you pay the $10,000 difference, or “deficiency,” then you have a $10,000 taxable gain.

There are some exceptions. For instance, debts that have been discharged through bankruptcy aren’t considered taxable income. Similarly, if you’re insolvent – your total debts are more than the fair market value of your total assets – when the debt is cancelled, some or all of the cancelled debt usually isn’t taxable.

In the case of non-recourse mortgages, there is no cancelled or forgiven debt. With these mortgages, the amount realized on foreclosure (or transfer in lieu of foreclosure) is never less than the outstanding debt. In other words, the price the property sells for at foreclosure is treated as the balance owed on the loan, no matter what the sale price may be.

The Mortgage Forgiveness Debt Relief Act (MFDRA)
Late in 2007, spurred by soaring home foreclosures, the MFDRA became law. Generally, it lets you exclude from your taxable income most if not all of any cancelled or forgiven debt that might come about because of a foreclosure. There are limits, however:

The cancelled debt has to be on your principal residence. The debt can be from a loan that you took out to buy, build, or substantially improve your home, or for refinancing the mortgage on your home. Because it applies only to your principal residence, commercial and vacation properties usually don’t qualify
Only debt that is forgiven in 2007, 2008, or 2009 qualifies
If you file a joint tax return with your spouse, you can exclude up to $2 million of forgiven debt from your income. If you’re married and file separately, you can exclude up to $1 million
You have to report the amount of forgiven debt on a special IRS form and attach it to your tax return
If your forgiven debt doesn’t qualify under the MFDRA, don’t forget about the insolvency and bankruptcy exceptions noted above.

Questions for Your Attorney
If given a choice, should I choose a recourse or non-recourse mortgage?
If I bid on my house at the foreclosure sale and win, can I still take advantage of the Mortgage Forgiveness Debt Relief Act?
I’m trying my best to pay my mortgage on time, but it’s getting harder each month. Realistically, I don’t see how I can avoid foreclosure in late 2009 or early 2010. Given that the Mortgage Forgiveness Debt Relief Act won’t apply after 2009, do you think I should stop paying my mortgage now and force the bank to foreclose?
Carmen Arruda

See if you qualify…before it’s too late:

First-time buyers can qualify for an $8,000 tax credit!

Move-up buyers can qualify for a $6,500 tax credit as long as you have lived in your home for five consecutive years out of the past eight years

Income limits have increased to $125,000 per individual and $225,000 per married couple

Buyers must enter into contracts written on or before April 30, 2010 and will have until June 30, 2010 to close escrow

For certain military personnel, the credit has been extended an additional 12 months.
Carmen Arruda

Undoubtedly there is significant negative sentiment towards the home buyer credit, particularly from those home buyers who could not take advantage of previous versions with lower income limits; and from most conservative groups and fiscally focused politicians who want the home buyer tax credit to expire as planned. However, in addition to allaying the weakness in the housing market, extending the home buyer credit again could be a smart political move in an election year. Lawmakers, now more than ever, are looking for any successful mortgage and/or housing-related program that they can stand behind. Besides the Fed’s mortgage-backed securities (MBS) purchase program, the home buyer tax credit has been touted by some as an extraordinary success. Such, “success” can provide the necessary political cover to advocate extending the credit, especially since the simple fact is that it if doesn’t work — that is, if it’s not being utilized — that it costs nothing. Deficit issues and the concept of whether we’re rewarding those who might have bought anyway will take a back seat. Keeping home sales going promotes home price stability, and that makes for less-grumpy voters as election time rolls around.

As of yet, there are only a few official rumblings about further extending the home buyer credit for new and existing home buyers. However, if the housing market and political climate continues to deteriorate I would not be surprised to see the credit extended again (albeit with slightly different conditions) to at least the end of the year.
Carmen Arruda

Undoubtedly there is significant negative sentiment towards the home buyer credit, particularly from those home buyers who could not take advantage of previous versions with lower income limits; and from most conservative groups and fiscally focused politicians who want the home buyer tax credit to expire as planned. However, in addition to allaying the weakness in the housing market, extending the home buyer credit again could be a smart political move in an election year. Lawmakers, now more than ever, are looking for any successful mortgage and/or housing-related program that they can stand behind. Besides the Fed’s mortgage-backed securities (MBS) purchase program, the home buyer tax credit has been touted by some as an extraordinary success. Such, “success” can provide the necessary political cover to advocate extending the credit, especially since the simple fact is that it if doesn’t work — that is, if it’s not being utilized — that it costs nothing. Deficit issues and the concept of whether we’re rewarding those who might have bought anyway will take a back seat. Keeping home sales going promotes home price stability, and that makes for less-grumpy voters as election time rolls around.

As of yet, there are only a few official rumblings about further extending the home buyer credit for new and existing home buyers. However, if the housing market and political climate continues to deteriorate I would not be surprised to see the credit extended again (albeit with slightly different conditions) to at least the end of the year.
Carmen Arruda