As if you didn’t have enough problems with managing or avoiding a foreclosure itself, you also need to consider tax consequences. The good news is, though, that the tax consequences after a foreclosure aren’t as severe now as they have been in the past – especially for those involved in foreclosures on their personal residences as opposed to investment properties.
Are You In a Recourse or Non-Recourse State?
State laws vary. The first thing you want to determine is whether you live in a recourse or non-recourse state, says Rosemarie Vincent, a Certified Public Accountant in Delray Beach, Florida. In some states, the lender can continue to go after you to collect on the unpaid balance of your home, even if you go through the whole foreclosure process. This can create a perverse incentive for the lender to sell the foreclosed home at a ridiculously low auction price – and then go after you for the difference. Potentially, your lender could get a judgment and even get a court order to garnish wages if you aren’t proactive in paying the debt.
In a non-recourse state, on the other hand, the lender can only recover the unpaid balance by selling the foreclosed property. They can’t go after you beyond that. If they can’t recover their investment when they sell the foreclosed property, they must write off the loan as uncollectable.
When a lender writes off a loan, however, it takes a tax deduction for it. This can potentially create a tax issue for you, the borrower. Why? Because debt forgiven by the lender, except if the debt is attached to a mortgage on a qualified personal residence, gets taxed as income.
Here’s how it works:
Suppose you owe $150,000 on a house, but you lost your job and fell behind on the mortgage payments. Suppose also that the house was only worth $120,000 when the bank foreclosed. That’s all the bank could get on the house at auction. In a recourse state, you could be liable for the $30,000 difference. In a non-recourse state, it’s the bank that has to eat the difference.
The Mortgage Forgiveness Debt Relief Act of 2007
A more recent law, the Mortgage Forgiveness Debt Relief Act of 2007, however, allows you to exclude up to $1 million cancelled or forgiven debt from your income – but only on mortgages secured by personal residences. Married couples filing jointly can exclude up to $2 million. Further, the law only applies on debt forgiven between 2007 and 2012. So if you’re coming down to the wire, you may want to get the bank to pull the trigger before the end of 2012. Otherwise, unless Congress changes the law, you could be on the hook for a large tax bill.
There are exceptions for those who are legally insolvent. If your forgiven debt exceeds your total net worth, you generally won’t get hit with a tax bill on forgiven mortgage debt.
Tax Consequences for VA Mortgage Foreclosures
You military veterans already know … the government never forgets a debt. The reason you don’t need a down payment on a Veterans Administration mortgage is because Uncle Sam guarantees the loan. If you default, the taxpayer picks up the tab – and you’re liable.
Balances you owe on a VA mortgage loan that goes into default are not typically dischargeable in bankruptcy. That is, you can’t make them go away, in most cases, simply by filing under Chapter 7. In fact, if you don’t pay the balance of the loan back, it could have indirect tax consequences for you: The IRS may attach future tax refunds until the loan is paid off.
This isn’t a huge deal if you never get a refund anyway. But for those of you working W-2 jobs and who have a deduction or two, you may not be able to count on that sweet refund cash every spring!
How To Report Forgiven or Cancelled Debt
If your lender forgives or cancels a balance on your mortgage, they will send you and the IRS a 1099-C form, entitled “Cancellation of Debt,” or a 1099-A, Acquisition of Abandoned or Secured Property. When you file your own personal income taxes, you must ordinarily declare the forgiven or cancelled debt on your individual tax return, using Form 1040, and attach IRS Form 982 to your return. Normally, you don’t need to fill out the whole form – just lines 1.e. and 2, and in some circumstances, line 10.e.
Tips for Minimizing Your Tax Bill
If you should receive a Form 1099-C or 1099-A, here are some tips directly from Nina Olson, head of the IRS’s Taxpayer Advocate Service:
1. Don’t ignore the form.
2. Check to see if the amount reported on the forms is correct.
3. Take a close look at the amount shown in box seven for the fair market value of the home that was repossessed. If it’s wrong, you will need to contact the lender and have them reissue a corrected form.
4. Try to pull together proof that supports your belief about what the fair market value of your home was at the time it was foreclosed.
5. Third, figure out how much of your home loan was used to buy or fix up your home. This information will help you figure out how much of the forgiven loan is not taxable under the new law.
6. If you were insolvent right before the debt was forgiven, your cancellation of debt is not taxable up to the amount of your insolvency.
Finally, don’t ignore the problem, warns Olson. If you don’t respond with a Form 982, the IRS will assume that you owe taxes on the entire amount forgiven – even though you may not.
For more tax information, see IRS Publication 4681, available on the IRS website.