So You Thought Your Home Foreclosure Was the End of Your Troubles, Huh? ( Part 2)

Author: Fred Daus

Last week we talked about homeowner cancellation of debt tax issues. This week we're going to talk about another tax consequence related specifically to home foreclosures. Did you know that the tax code treats losing a home to foreclosure as a sale and may result in a taxable gain or loss? (Yes, I am beginning to feel I should recant my statement from last week that Government isn't entirely heartless.)
Foreclosure may seem like the end of the road, but wait! There's more!
Let's break it down and see how this plays out: A homeowner purchased a house back in 1999 for $100,000 ($10,000 down and a $90,000 mortgage). Over time, the price of the house increased substantially until, in 2005, the house was worth $250,000. That same year, the owner established a home equity line of credit and subsequently borrowed $50,000. The loan proceeds were used to pay off credit cards, medical bills, and a car loan.
Unfortunately, the homeowner was laid off in 2008 and could no longer make the mortgage and home equity payments. During the same time, the value of the house dropped to $120,000, yet the total balance of the mortgage and home equity loan was $135,000. This leaves the homeowner owing $15,000 in cash in order to sell the home. Since the homeowner was unemployed and had little to no savings, selling the house was not a feasible option.
After several months of missed loan payments, the bank foreclosed and took possession of the home. Shortly thereafter, the bank sold the house at auction for $120,000. Since the sale price for the house could not cover the total loan balance and the home owner was unemployed, the bank decided to cancel the remaining unpaid balance of $15,000.
Seems like "problem solved" for the homeowner, right? Not quite.
Using a worst-case scenario, the homeowner who is unemployed and lost their home to foreclosure would have to pay an additional $5,250 in income taxes.
In this situation, there are two separate tax calculations: cancellation of debt and abandonment of property due to foreclosure. To simplify matters we'll only be looking at the abandonment of property in detail.
When a bank forecloses on the property the homeowner will receive a 1099-A (along with a 1099-C, if applicable). The 1009-A will show the outstanding loan balance and the home's fair market value when foreclosure occurred. For tax purposes, the foreclosure is treated as sale with any gain or loss. In this example, the gain on abandonment is $20,000 ($120,000 fair market value less $100,000 basis). Assuming the homeowner meets primary home exclusion (discussed in my last blog), the gain would not be taxable. If the homeowner did not meet the exclusion, an ordinary gain of $20,000 would be included on homeowner's tax return.
Again, let's assume the homeowner is in the 15% tax bracket for this particular year and had to include the $20,000 as income. The foreclosure would cost the homeowner an additional $3,000 in taxes. Let's not forget the potential for additional income tax due to cancellation of debt. Assuming the canceled debt of $15,000 could not be excluded from taxes, the taxable income would increase by that amount which would result in an additional $2,250 of income tax ($15,000 x 15% tax rate). Using a worst-case scenario, the homeowner who is unemployed and lost their home to foreclosure would have to pay an additional $5,250 in income taxes.
I should point out here that many foreclosed home owners will not fall under this worst-case scenario since tax laws have certain protections for primary residence homes. However, there are no protections in place for owners of foreclosed rental real estate properties.
If you find yourself one of the millions of Americans facing this kind of situation I would definitely recommend seeking the advice of a reputable Accountant. The tax laws related to foreclosed real estate property are very complicated and shouldn't be taken lightly or ignored. The IRS doesn't accept ignorance as an excuse and won't be likely to offer any leniency in such cases so be proactive, get good advice and avoid taking your situation from bad to worse.
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Fred Daus is the Chief Executive Officer and founder of Fredrick James Accounting, Tax & Consulting. He is a member of National Society of Accountants and the National Society of Tax Professionals and has been helping clients save money since 2001. Fredrick James is an innovative, full service accounting firm in Clearwater, Florida with a focus on providing outstanding service, tax savings and financial growth to clients in the Tampa Bay area and Nationwide. Visit our website www.FredrickJames.com or call 727-230-0716 for more information.