What are the Tax Consequences After Foreclosure?

by on April 15, 2012Jason Van Steenwyk

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?

tax consequences after foreclosureState 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.

{ 6 comments… read them below or add one }

beckie February 3, 2014 at 5:42 pm

we put our house up for sale in 2006 and were having a house built. we moved to the new house in 2007. the old house never sold (both in florida). we paid both mortgages until 2009. the house still hadnt sold and the value had plummeted. the former house fell into forclosure and it wasnt complete until 2013. we received a 1099 from the former servicer for a full debt forgiveness. will the foreclosure relief act be able to help us? if we had known the house couldnt sell we never would have moved. we never had any intention of owning two homes…help!!!

Reply

Mike October 2, 2013 at 11:53 am

In the State of FL. my husband sold a piece of property and held the mortgage. At the time of sale our accountant told us we could take the tax hit on the full 150,000.00 or space it over time we decided to take the hit at the time of sale. The purchasers paid for a few years then defaulted on the loan. They also owed back taxes of about 11,000.00. The purchaser who defaulted asked our attorney if we would consider taking the property back and paying the back taxes as they had no money. To make a long story short, we agreed to that and had all the paperwork drawn up. What happens to the tax we already paid?

Reply

Edna Thompson August 10, 2013 at 9:21 am

My husband and I had a home in Florida that was foreclosed on in 2012. Due to a lengthy hospital stay and medical expenses in addition to losing my job, we filed for bankruptcy. Because we have not yet received the final judgement on the foreclosure, we have continued to pay the H.O.A. fees. Since I have have been given conflicting advice, my question is, should we continue paying the H.O.A. fees even though the debt has been discharged in bankruptcy? What are the repercussions if we stop paying these fees? I am currently receiving disability and my husband is retired so we live on a very limited income.Your advice will be greatly appreciated.

Reply

laura demello January 28, 2013 at 1:18 pm

my house was just foreclosed on and sold. can they take the money out of my 401k i am worried about that?

Reply

Jason Van Steenwyk January 29, 2013 at 5:05 pm

Hello, Laura,

For the most part, your 401(k) is not at risk. It’s an ERISA-qualified pension plan, and as such receives quite a bit of asset protection. The specifics depend on the law in your state, but as long as your plan does not allow in-service withdrawals, they won’t be able to attach it. That’s because the 401(k) isn’t even your money. It’s held in trust for you by a third party, and they can’t release it to anyone else except in your best interest.

There’s a bit of gray area if you are able to take withdrawals from your 401(k). A creditor can potentially get a charging order, which could divert part of your 401(k) income to them.

If it’s a personal home in a non-recourse state, you don’t have much to worry about.

If it’s not in a recourse state, and/or if it’s an investment property, then the lender could potentially sue and get a judgment against you, but Getting a judgment is different than collecting, though. And it’s VERY difficult to attach a 401(k).

IRAs receive up to 1 million of protection, under federal law, as well – and some states grant them more protection than that.

The charging order may allow them to attach payments when you start withdrawing money, but only the most patient creditors (and the IRS) will typically do so.

Now, there are a lot of things, as you can see already, that are dependent on your jurisdiction and your personal circumstances. I would definitely consult an experienced attorney, licensed in YOUR STATE, and find out what your options are, whether bankruptcy makes sense rather than lose a critical asset, etc.

By the way, if you smell a judgement or lawsuit coming, you can’t dodge it by transferring assets out of your name. To do so would run afoul of fraudulent conveyance rules. Hiding assets is a lousy strategy. The beauty of a 401(k) plan, and other pension plans, is that you can have them in plain sight and there’s not much a creditor can do about it!

Best of luck, and thanks for writing!

Jason

Reply

Property Tax Refund June 16, 2012 at 11:34 am

Now a days property and real estate tax is major issue in public you provide information about tax refund which is useful for every person thanks for sharing such a nice & informative information.

Reply

Leave a Comment