Income Taxes

The income tax consequences of a foreclosure, short sale, or deed-in-lieu of foreclosure, can be extremely complicated.  This web site can only give a very general and conceptual picture, and cannot provide advice that is applicable to your individual situation.  This website is not a substitute for the advice of a tax professional.

Whether your home is sold consensually (regardless of price), is sold at a foreclosure sale, or is transferred back to the lender by way of a deed-in-lieu of foreclosure agreement, each of these transactions is treated as a “transfer” by the IRS.  At the time of transfer, there are two tax concepts that you need to be aware of.  The discussion below is limited to residential property where the owner has used the property as a primary residence for at least two of the last five years.  The rules are different for investment property, and we are not attempting to cover that subject here.

1. Capital Gains.  A capital gain occurs if the transfer price is greater than the tax basis in the property.  The tax basis of the property, for a house used as a principal residence by the owner, is the purchase price plus any significant improvements, such as additions, new roof, etc.  Normal maintenance is not considered an improvement that adds to basis.  The transfer price is generally the fair market value of the residence, not the price that it sold for at the foreclosure sale.  If the residence was used as a primary residence by its owner for at least two of the last five years, some of the capital gains may not be taxed.  A married couple can exclude $500,000 of capital gain, and a single person can exclude $250,000.

2. The second tax concept is cancellation of debt (COD) income.  If you have borrowed money, and do not pay it back to a lender, the IRS will typically consider the funds to be income to you.  This occurs even if you never had the money in your hand or bank account when you borrowed it.  The logic is that if you borrowed money and used it to purchase a residence, and then you did not repay all of the money that you borrowed, it is the equivalent of a gift from the lender to you.  You experience COD as a 1099 tax form at the end of the year, and you will show COD as additional income on your tax return, which means you will have to pay taxes on that income.

To determine if COD will be an issue there is one more concept that comes into play.  COD only applies in the case of what are called “recourse” loans.  “Recourse” means that the lender can pursue the borrower for a deficiency (meaning sue them) if the lender forecloses, or takes the property back via a deed-in-lieu of foreclosure, and does not get enough money from the sale of the property to pay off the borrower’s loan(s).  A non-recourse loan on the other hand means that the lender can only pursue the property (via foreclosure or taking a deed-in-lieu of foreclosure) and cannot sue the borrower for a deficiency if the foreclosure (or deed-in-lieu of foreclosure) generates less money than is owed.  A person whose property has declined in value and is now worth less than what is owed on it may be at risk for COD income if they have a recourse loan.  Many states, California for example, have laws which prevent recourse loans if the loan is used for the purchase of a residence. 

In December 2007, the President signed a law that makes up to $2,000,000 of COD income non-taxable if the debt was “acquisition indebtedness,” meaning that the loan in question was used to purchase the residence.  Refinance loans qualify for acquisition indebtedness if the new loan replaced an existing loan (refinance to lock or get a better interest rate).  If the refinance loan generated cash for the borrower (known as a cash-out refi), the amount of cash taken by the borrower is not exempt.  This act makes the IRS treat purchase money “recourse” loans like they were “non-recourse” loans.

Helpful Links:

IRS Article on Understanding Taxes