Been foreclosed on? Don’t forget your taxes

From press release

URBANA, Ill.—As if losing your house weren’t bad enough, you may owe capital gains taxes after a foreclosure, said a University of Illinois Extension consumer and family economics educator.

A foreclosure is treated as a sale or exchange from which you may realize a gain or a loss, and it must be reported in the same way. See IRS Publication 544,

said Susan Taylor.

This is true even if you voluntarily return the property to the lender. You may also realize ordinary income from cancellation of debt if the loan balance is more than the fair market value of the property,

she added.

In 2007, the Mortgage Forgiveness Debt Relief Act generally allows taxpayers to exclude income from the discharge of debt on their principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for this relief, she said.

The provision applies to debt forgiven in calendar years 2007 through 2012. Up to $2 million of forgiven debt is eligible for this exclusion ($1 million if you are married filing separately). The exclusion does not apply if the discharge is due to services performed for the lender or for any other reason not directly related to a decline in the home’s value or the taxpayer’s financial condition,

she said.

For more information, including detailed examples, see IRS Publication 4681,
Canceled Debts, Foreclosures, Repossessions, and Abandonments.

Also see IRS news release IR-2008-17.

Here’s an example of a situation in which a gain must be reported.

Anna paid $200,000 for her home. She paid $15,000 down and borrowed the remaining $185,000 from a bank. The house’s deed is held as collateral until the loan is paid off. When Anna stopped making payments, the bank foreclosed on the loan. At that time, the balance due was $180,000, the fair market value of the house was $170,000, and her adjusted basis was $175,000 due to a casualty loss she had deducted.

The amount Anna realized on the foreclosure is $180,000, the debt canceled by the foreclosure. She figures her gain or loss by comparing the amount realized ($180,000) with her adjusted basis ($175,000). She has a $5,000 realized gain.

Here’s an example of a situation in which money may be owed the IRS from amount realized on a recourse debt:

When you are personally liable for recourse debt, the amount realized on the foreclosure does not include your income from cancellation of the debt. If the fair market value of the transferred property is less than the canceled debt, the amount realized includes the canceled debt up to the fair market value of the property. You are treated as receiving ordinary income from the canceled debt for the part of the debt that is more than the fair market value.

Assume the same facts as in the example, except that Anna is personally liable for the loan (for example, she co-signed a loan for an adult child or relative, which allows the lender to come after her in case of a default on the loan). In this case, the amount she realizes is $170,000. This is the canceled debt ($180,000) up to the fair market value of the house ($170,000). She figures her gain or loss on the foreclosure by comparing the amount realized ($170,000) with her adjusted basis ($175,000).

Anna has a $5,000 nondeductible loss, and she is treated as receiving ordinary income from cancellation of debt. (The debt is not exempt from tax under IRS rules for Cancellation of Debt.) That income is $10,000 ($180,000 minus $170,000). This is the part of the canceled debt included on the amount realized.

Confused yet?
The IRS provides worksheets to help you figure out how much you may owe as a result of foreclosure or repossession,

Taylor said.

And the income may not be taxable, she said.
Individuals should report the income from cancellation of a non-business debt as other income on Form 1040, line 21.

For more information about the tax consequences of foreclosure, visit www.irs.gov or consult a tax professional, said Taylor.

For other good advice on getting through tough financial times, including which bill to pay first, how to talk to your creditors, how to save food dollars, how to talk to your children about your financial situation, and more, visit U of I Extension’s
Getting Through Tough Financial Times

Web site at http://www.ToughTimes.illinois.edu.

From the September 2-8, 2009 issue

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