Taxes After Foreclosure?

Question

After speaking to a realestate Attorney, I was told after foreclosure the amount we have as capital gain, will then written off as a loss due to the market value dropping. The likley hood of them doing a civil case against is low because of them having so many foreclosures. What do you think?

Answer 1

I think you need to consult with a tax expert, not a real estate attorney.

There are 2 separate and distinct issues here -- the gain on the sale and the tax treatment of any debt that is forgiven.

A foreclosure is treated as any other sale as far as the IRS is concerned. It's entirely possible to have a foreclosue that generates a taxable capital gain while leaving significant debt unpaid. This is common with homes bought many years ago for relatively low prices and then recently re-mortgaged by the owner who now cannot pay the mortgage. Their basis is what they paid for it years ago and the sales price is whatever it brings at auction or the balance of the mortgage if it does not sell. Even with the exclusion of the gain on the sale of a principal residence, in parts of the country such as CA it's very possible to exceed the exclusion amount and have a taxable capital gain situation.

After the sale is dealt with, there's the issue of any remaining debt. How that is treated depends upon the mortgage and the rest of your financial situation.

If the mortgage is non-recourse then there is nothing to worrry about as the foreclosure pays the loan in full. Any remaining debt is lost to the lender and not taxable to you.

If the mortgage is with recourse and the lender forgives the remaining debt you will receive a From 1099-A or 1099-C at the end of the year showing the amount forgiven. That is considered taxable income to you. However if you are insolvent at the time of the forgiveness of the debt you may avoid the tax on it. You file Form 982 along with a financial statement that shows your insolvency. Any amount of forgiven debt up to the amount of your insolvency (the amount that your liabilities exceed the value of your assets) is not taxable income to you.

The calculations can be a bit tricky. You should hire a tax pro who specialized in this type of issue. Don't trust this to a real estate attorney or, worse yet, a part-timer at a storefront tax prep mill.