As far as the Internal Revenue Service is concerned, a foreclosure is treated the same as the sale of a property. The bottom line is that once it was yours and now you no longer own it. The event can trigger a capital gain and, in some cases, you might also owe income tax on the amount of any part of the mortgage debt that’s been forgiven or canceled. The sale of real property normally goes through an escrow process. The seller receives statements showing how much the home was sold for. There’s no escrow period with foreclosures, however, lending bank simply takes possession of the home. The basic formula for calculating capital gains is to subtract the basis or cost of the property from the sales price. The difference is how much of a profit the seller made, or how much money was lost in the transaction.
In a foreclosure situation and without escrow statements, there’s no mutually agreed-upon sales price, but, there’s still a “sales price” for tax purposes. It will be either the fair market value of the property as of the date of the foreclosure, or the outstanding loan balance immediately prior to the foreclosure. It will depend on the type of mortgage loan you had. Your mortgage was either recourse or a non-recourse loan.
If you had a recourse loan, this means that you’re personally responsible for the debt. The lender can pursue you for repayment even after the property has been repossessed—it has “recourse.” In this case, the figure used as the sales price when calculating any potential capital gain is the lesser of the following two amounts:
• The outstanding loan balance immediately before the foreclosure minus any debt for which the borrower remains personally liable after the foreclosure
• The fair market value of the property being foreclosed
In addition to a capital gain, you can have canceled debt income from the foreclosure with this type of loan as well. Mortgages used to acquire homes tend to be non-recourse loans, while refinanced loans and home equity loans tend to be recourse loans. This is by no means an absolute rule, however. It can also depend on the state in which you reside.
A non-recourse loan is one where the borrower isn’t personally liable for repayment of the loan. In other words, the loan is considered satisfied and the lender can’t pursue the borrower for further repayment if and when it repossesses the property. The figure used as the sales price is the outstanding loan balance immediately before the foreclosure of a non-recourse loan. The IRS takes the position that you’re effectively selling the house back to the lender for full consideration of the outstanding debt, so there’s generally no capital gain. You won’t have any canceled debt income, either, because the lender is prohibited by law from pursuing you for repayment. You’ll Receive Tax Reporting Documents
• Form 1099-A is issued by the bank after real estate has been foreclosed upon. This form reports the date of the foreclosure, the fair market value of the property, and the outstanding loan balance immediately prior to the foreclosure. You’ll need this information when you’re reporting any capital gains related to the property.
• Form 1099-C is issued by the bank after the bank has canceled or forgiven any debt on a recourse loan. This form will indicate how much debt was canceled. You might receive only a single Form 1099-C that reports both the foreclosure and the cancellation of debt instead of receiving both a 1099-A and a 1099-C if your lender both forecloses on the home and cancels the unpaid debt in the same year.
Reporting a Capital Gain or Loss
You can determine the sales price after you’ve determined what type of loan you had on your property. Report the foreclosure on Schedule D and Form 8949 if the foreclosed property was your primary residence. You might qualify to exclude up to $500,000 of gain from taxation subject to certain rules:
• The home was your primary residence.
• You owned the home for at least two of the last five years (730 days) up to the date of sale.
• You lived in the home for at least two of the past five years ending on the date of foreclosure.
Individual taxpayers can exclude up to $250,000 in gains, and married taxpayers filing jointly can double that amount. If the foreclosed property was mixed-use it was your primary residence at one time and a secondary residence at another time you can still qualify for an exclusion from capital gains tax under the modified rules for calculating your gain or loss. The rules are also relaxed somewhat for members of the armed forces.
Capital Gains Tax Rates
As of tax year 2019, the rate on long-term capital gains for properties owned one year or longer depends on your overall taxable income and filing status.
• 0% if taxable income is under $39,375
• 15% if taxable income is from $39,375 to $434,550
• 20% if taxable income is over $434,550
Heads of household:
• 0% if taxable income is under $52,750
• 15% if taxable income is from $52,750 to $461,700
• 20% if taxable income is over $461,700
Married Filing Jointly and Qualifying Widow(er)s:
• 0% if taxable income is under $78,750
• 15% if taxable income is from $78,750 to $488,850
• 20% if taxable income is over $488,8503
These long-term capital gains income parameters are different from those that were in place in 2017. Rates were tied to ordinary income tax brackets before the Tax Cuts and Jobs Act (TCJA) went into effect. The TCJA assigned them their own brackets. It’s a short-term capital gain if you owned your home for less than a year. You must pay capital gains tax at the same rate that’s applied to your regular income in other words, according to your tax bracket.
When Discharged Debt Is Taxable Income
The Mortgage Forgiveness Debt Relief Act of 2007 (MFDRA) provided that taxpayers could exclude from their taxable incomes up to $2 million in discharged mortgage debt due to foreclosure a nice tax break indeed. Prior to 2007, discharged debt was included in taxable income. Then the MFDRA expired at the end of 2017, so discharged debt was once again considered to be taxable income by the IRS. Fortunately, this provision of the tax code is back again, at least for foreclosures that occur from Jan. 1, 2018 through Dec. 31, 2020. Title I, Subtitle A, Section 101 of the Further Consolidation Appropriations Act of 2020, signed into law by President Trump in December 2019, extends this provision through the end of 2020.5 You no longer have to concern yourself with paying income tax on debt discharged through foreclosure, at least through the end of 2020 and if your forgiven debt doesn’t exceed $2 million.
How Much Will a Foreclosure Affect a Tax Refund
Foreclosure is one of those difficult experiences certain homeowners may have to go through. Not only does foreclosure affect your credit rating, but it also can make it difficult to purchase another home in the immediate future. Additionally, there may be tax consequences attached to your foreclosure. In certain cases, foreclosed homeowners have been hit with a significant tax bill that often reduces or eliminates any tax refund due.
Foreclosure Tax Consequences
Often, the Internal Revenue Service (IRS) considers debt that’s forgiven by a lender because of foreclosure to be taxable income. Through calendar year 2012, the IRS is waiving taxation of mortgage debt forgiveness in certain cases. Because the IRS is waiving taxation of forgiven mortgage debt, any income tax refund isn’t affected by your foreclosure. However, foreclosures occurring in 2013 and beyond could affect the income tax refunds of those experiencing foreclosures. After foreclosure, the IRS could consider taxable any cash you took from your home as the result of a refinance. In addition to cash-out income, any income you took from a home equity line of credit (HELOC) could be taxable under IRS rules. Your forgiven mortgage debt and income gained from refinances or HELOCs might also be taxable at the state level.
Reporting Foreclosure Income
Taxable income resulting from forgiven mortgage debt and any cash-out refinances or HELOCs has to be declared in the year in which the foreclosure occurred. IRS taxation waivers of forgiven mortgage debt apply only to principal residences. However, money taken from a cash-out refinance or HELOC that’s applied to home renovation or improvement is often tax-exempt after foreclosure. Also, ensure the federal income reporting document (Form 1099) your mortgage lender gives you after your foreclosure is accurate.
Federal law considers debt discharged in bankruptcy, including potentially taxable forgiven mortgage debt, to be non-taxable as a result. Insolvency immediately before mortgage debt is forgiven also could exempt you from taxation of that debt. According to the IRS, insolvency is when the total of your liabilities exceeds the fair market value of your assets. Consult a tax professional if you’ve recently experienced foreclosure in order to discuss any income tax and tax refund implications.
Difference between A 1099-A and 1099-C
Selling real estate in this precarious market can be quite a task in and of itself. When the dust clears, sellers often are left to navigate through a maze of issues, not sure what to expect next. Many sellers have no idea what tax forms to expect from the lender, so they have no way of knowing if they received them. Two forms in particular, the 1099-A and 1099-C, create much of the confusion for sellers, their lawyers and their financial advisors. Every time real property is sold or transferred, the IRS must be notified. In a traditional sale of property, the seller will receive a Form 1099-S (Proceeds from Real Estate Transactions) to report the sale of the property to the IRS. This form is used to determine whether there is a gain or loss on the sale of the property. In a short sale or deed in lieu of foreclosure, the seller also receives a 1099-S because the property is sold willingly.
1099-A: Acquisition or Abandonment of Secured Property
However, in the case of a foreclosure, no 1099-S is issued because the “sale” is involuntary. Instead, the seller will receive a 1099-A (Acquisition or Abandonment of Secured Property) to report the transfer of the property. The 1099-A reports the date of the transfer, the fair market value on the date of the transfer and the balance of principal outstanding on the date of the transfer. Just like the 1099-S, the 1099-A is used to determine whether there is a gain or loss on the sale of the property. Many sellers mistakenly believe that if their property is sold in a foreclosure auction, they will not have any capital gain. This is not always the case. As a result of the adjustments to cost basis in certain situations, there may be a capital gain on property that is sold in a foreclosure auction. This may cause yet another source of unexpected tax liability that the seller is unable to pay.
1099-C: Cancellation of Debt
Now that short sales have become so common, many sellers understand they may receive a 1099-C (Cancellation of Debt), to report the cancellation of debt resulting from a short sale or deed in lieu of foreclosure. What comes as a surprise to many sellers is that they may receive a 1099-C as a result of foreclosure sale as well. Some sellers believe that if they allow their property to go into foreclosure, they will avoid the tax consequences of the cancellation of debt. However, the tax ramifications are the same for cancellation of debt income, whether it is generated from a short sale, deed in lieu of foreclosure or foreclosure. At the time the seller/borrower obtained the loan to purchase or refinance the property, the loan proceeds were not included in taxable income because the borrower had an obligation to repay the lender. When that obligation to repay the lender is forgiven or cancelled, the amount that is not required to be repaid is considered income by the IRS. The lender is required to report the amount of the cancelled debt to the borrower and the IRS on Form 1099-C, when the forgiven debt is $600 or greater. There are certain exclusions that can be used to reduce or eliminate the cancellation of debt income from taxable income. This includes discharge of the debt in bankruptcy, insolvency of the seller before the creditor agreed to forgive or cancel the debt, or, if the seller qualifies, relief pursuant to the Mortgage Forgiveness Debt Relief Act (MFDRA).
To summarize, any sale or transfer of property, whether voluntary or involuntary, must be reported to the IRS. Form 1099-S is used for a traditional sale, short sale or deed in lieu of foreclosure; Form 1099-A is used for a foreclosure. A lender may forgive or cancel debt in any case – where it’s a short sale, deed in lieu of foreclosure, or foreclosure – which will result in the issuance of a 1099-C. In order to properly report these transactions on the tax return, sellers should seek advice from an experienced tax professional. When homeowners fall into lender foreclosure, several things may end up affecting them, including potential tax issues. The Internal Revenue Service treats foreclosures as sales of property and those properties’ former owners could be liable for certain federal income taxes. After foreclosure your lender may send you IRS Form 1099-A, Acquisition or Abandonment of Secured Property. Form 1099-A is used to show three key pieces of information that helps foreclosed homeowners determine their tax liability, if any. The IRS considers canceled mortgage debt that results when a borrower is foreclosed as income to that borrower. To account for their cancellation of foreclosed mortgage borrowers’ debt, mortgage lenders send them IRS Form 1099-A. Foreclosed mortgage borrowers’ principal loan balances are shown on Form 1099-A’s Box 2 and the fair market value (FMV) of their foreclosed properties in Box 4. Box 5 of Form 1099-A indicates whether foreclosed borrowers are personally liable for repaying their mortgage loans. Whether you’ll owe taxes on your foreclosure’s lender-canceled debt also depends on Box 5 of Form 1099-A. Mortgage borrowers shown in 1099-A’s Box 5 to be personally liable for repayment of their mortgages could face taxable income liability. States such as California are non-recourse and lenders foreclosing no judicially or without the courts can’t pursue borrowers for negative loan balances or deficiencies. Foreclosed borrowers in non-recourse states might not be held personally liable for repaying their foreclosed mortgages, thus eliminating any tax liability.
The difference between a mortgage’s principal balance shown in IRS Form 1099-A’s Box 2 and Box 4’s FMV is important. For example, if your foreclosed mortgage loan’s principal balance is $100,000 and its FMV $50,000, that $50,000 difference could be taxable income. Your mortgage lender could also overestimate your former home’s FMV shown in Box 4 of your 1099-A. Consider an appraisal to obtain an accurate FMV of your foreclosed home if you’re concerned about possible future tax liability. Foreclosing lenders might issue IRS Form 1099-A to borrowers as a kind of placeholder until they decide whether to issue Form 1099-C. In some cases, foreclosing mortgage lenders need time to decide whether they’ll be canceling their foreclosed borrowers’ mortgage debt. Mortgage lenders may issue Form 1099-A to borrowers and file copies with the IRS to indicate a foreclosure has occurred and that a debt cancellation decision is pending. If you’re issued Form 1099-C after foreclosure your lender has definitely canceled your mortgage loan’s debt.
Taxable Income Exclusions
It’s possible to exclude from taxable income lender-canceled mortgage debt resulting from a home foreclosure. The most common exclusion to the tax liability resulting from lender-canceled mortgage debt comes from the Mortgage Debt Relief Act of 2007. Through Dec. 31, 2012, mortgage borrowers whose principal residences were foreclosed may be able to exclude up to $2 million of lender-canceled debt. Insolvent foreclosed mortgage borrowers, with debts exceeding assets, may also be able to exclude lender-canceled debt from taxable income. The foreclosure itself is treated as a sale of the home. So, you might need to report it on Schedule D. You should receive Forms 1099-A with information about the sale.
What you’ll report as the amount realized on the sale depends on which of these applies:
• If you were personally liable for the loan. This is called a recourse loan.
• If you weren’t personally liable for the loan. This is called a nonrecourse loan.
On a recourse loan, the amount realized on the sale is the lesser of:
• The outstanding debt right before the foreclosure. Subtract any amount for which you remain liable right after the transfer.
• The fair market value (FMV) of the property transferred
On a nonrecourse loan, the amount realized on the sale is the full amount of the debt outstanding. This is as calculated right before the foreclosure.
You might be able to exclude the capital gain under the sale-of-principal-residence exclusion if both of these are true:
• You have a gain on the sale.
• The home was your main home.
Cancellation of Debt
If you were liable for the loan, you might have cancellation of debt income. You should receive a Form 1099-C with this information. This is usually the total amount of debt owed right before the foreclosure, minus the property’s FMV. Cancellation of debt income from property secured by a recourse debt is taxable. This is true unless exclusion applies. There are exclusions for these:
• Debt cancelled in a bankruptcy proceeding
• Qualified principal residence indebtedness
• Insolvency (your debts are more than your assets)
Foreclosure Attorney Free Consultation
When you need legal help with a foreclosure in Utah, please call Ascent Law LLC for your free consultation (801) 676-5506. We want to help you.
8833 S. Redwood Road, Suite C
West Jordan, Utah
84088 United States
Telephone: (801) 676-5506