Real Estate Update in Palo Alto & Los Altos

If you thought a bank foreclosure ended the financial miseries associated with your former home, think again. You could soon be hearing from the IRS about taxes due in connection with the residence you no longer own.

“You can walk away from the big house payment, but not from the potential tax implications,” says John W. Roth, senior tax analyst at CCH in Riverwoods, Ill. “And if you couldn’t afford the mortgage, you probably can’t afford the taxes.”

As the lending crisis continues to shake out, more homeowners, particularly those who used creative mortgages to buy their houses, could be in this predicament. Even long-time homeowners who refinanced their properties based on increased value when the real estate market was hot could find themselves in tax trouble if they lose their properties to the bank.

The issue is complicated by many factors. There are, of course, the financial problems that have led to the foreclosure process. Add to that the loan terms (some of which employed those creative mortgage products), the housing market in your area and, of course, federal tax laws, and you’ve got a recipe for financial disaster.

Forgiven but not forgotten
In many cases, the tax problem associated with a foreclosure arises from a seemingly benevolent move — the lender forgives some of the loan. This happens when a lender and a borrower negotiate a reduction in the loan amount. It also happens when the lender forecloses on the property and sells it for less than the outstanding mortgage.

In both instances, the difference for which the borrower is no longer responsible is usually considered cancellation of debt, or COD income. It also is called discharge of indebtedness income or discharge of debt. Regardless of the name, under the tax code, it’s all taxable income. The tax on COD is calculated at ordinary rates, which range from 10 percent to 35 percent depending upon your income.

“What the tax law essentially does is treat the foreclosure as a sale by the debtor, the owner of the property, with the proceeds being paid to the lender,” says Frederick M. Stein, RIA senior analyst from Thomson Tax & Accounting. “And any debt owed above and beyond those proceeds is cancellation of indebtedness income.”

That’s why financially struggling homeowners who are considering turning over the house keys to the bank should think twice. While sending the lender “jingle mail,” a term coined to describe the sound of a key-containing envelope, will get you out from under the burden of the monthly house payment, it won’t prevent a tax bill in your mailbox.

“People who advise you to walk away talk about payment consequences, not the tax consequences,” says Stein. “If they owe $50,000 and $10,000 is forgiven, they think of it as a gift. It may be a gift from the lender, but not from the IRS.”

Roth adds, “The IRS is far more tenacious than most banks. Their responsibility is to collect the tax on the income you have.”

The type of mortgage matters
Just how much and what type of tax the IRS expects after a foreclosure depends in large part on whether the loan is of the recourse or nonrecourse variety.

With a recourse loan, the debtor is personally liable for the debt. In a foreclosure, it means if the property sale proceeds are not enough to cover the outstanding mortgage, the debtor must pay the difference. This includes interest that accrues during the foreclosure process.

A nonrecourse debt, however, is secured by the loan collateral. If money from sale of the property doesn’t cover the outstanding debt, the lender has no legal ability to get the additional funds from the debtor.

“In nonrecourse situations, you have a house, the mortgage and the market value of whatever the bank can sell it for and put toward the outstanding loan,” says Ted Lanzaro, CPA and owner of his own accounting firm in Shelton, Conn. “If the house is worth $100,000 and there is a $110,000 loan on it, the bank in a nonrecourse situation cannot go after the borrower for that $10,000 difference.”

Cancellation of debt income and its tax implications typically come into play with recourse loans. If the house’s fair market sales price is less than the unpaid mortgage and the lender forgives the remaining mortgage debt, that amount is taxable income at ordinary tax rates.

With either type of mortgage, a foreclosed-upon homeowner could end up owing capital gains taxes without ever receiving any money from the foreclosure sale.

A sale is a sale is a sale
“Foreclosure is not a sale in normal terms, but it is still treated under tax code as a sale,” says Stephen Trenholm, CPA and tax manager at Rucci Bardaro & Barrett in Boston.

“The outstanding balance of the mortgage is compared to the basis in house. If that produces a gain, it’s a taxable gain. If it’s a nonrecourse mortgage, it’s a capital gain.”

That’s right. Even though you aren’t selling the house and the bank is, the IRS views the transaction as if you were the seller. That means you could owe taxes on the sale. The bad news comes directly from the IRS, via Publication 544:

“If you do not make payments you owe on a loan secured by property, the lender may foreclose on the loan or repossess the property. The foreclosure or repossession is treated as a sale or exchange from which you may realize gain or loss. This is true even if you voluntarily return the property to the lender. … You figure and report gain or loss from a foreclosure or repossession in the same way as gain or loss from a sale or exchange. The gain or loss is the difference between your adjusted basis in the transferred property and the amount realized.”

Those calculations also take into consideration any cancellation of debt income and the type of mortgage.