Federal Law Provides Tax Relief for Foreclosure Sales
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UPDATED: Sep 6, 2012
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If you have had a home foreclosed, you may find yourself facing a tax bill from the Internal Revenue Service (IRS) after the process has completed. The IRS is able to tax you because the foreclosure is known as a taxable sale, even if you transfer the deed of your house to the lender in satisfaction of the debt (a process called “deed in lieu of foreclosure”). Just because you were forced to sell the house by a foreclosure proceeding does not mean the transaction is not a taxable sale.
The IRS is able to tax your gain from the foreclosure sale. To figure out how much you gained on the foreclosure, take the difference between the amount realized in the sale and the adjusted tax basis of the home. The adjusted tax basis is generally the price you paid for the home plus the cost of any major improvements, and the amount realized will depend on whether the mortgage is a recourse or non-recourse loan:
- Recourse Loan – A recourse loan means that you are personally responsible for paying the balance of the mortgage if your foreclosure sale doesn’t cover the full debt. The amount realized for a recourse loan is the home’s fair market value (usually the sale price) minus the expenses of the sale.
- Non-Recourse Loan – A non-recourse loan means that you are not personally liable to the mortgage lender for the debt, and the only thing the lender can do is foreclose on the home and keep the proceeds up to the amount owed. The amount realized in a non-recourse foreclosure is the amount you owe on the mortgage plus any interest that comes due at the time of the foreclosure.
The value that represents the difference between your adjusted tax basis and the amount your realized from the foreclosure sale is the taxable gain. Whlie you may not think that you gained anything by selling your home in foreclosure, the IRS views every cancelled debt as a taxable gain becaues a debt cancelled is, essentially, money earned by not paying.
This rule applies to any debt that is cancelled, and for a long time foreclosures were no exception. However, in 2007, due to the rapid increase in home foreclosures, tax relief for owners selling homes in foreclosure came when the Mortgage Forgiveness Debt Relief Act (MFDRA) was signed into law. The MFDRA generally allows a homeowner to exclude from taxable income any cancelled or forgiven debt that may be satisfied by way of foreclosure. With the passage of the MFDRA, foreclosed homeowners could find relief from federal taxes on the sale of their home. There are limitations:
- The debt must be related to the principal residence. Any debt incurred to purchase, improve, or refinance your principal residence qualifies, but any debt related to commercial or vacation properties will not.
- Only debt that is forgiven between 2007 – 2012 qualifies
- You can only exclude up to $2 million of forgiven debt for joint returns, and $1 million for individual returns.
- You have to report the amount of forgiven debt on a special IRS form, and attach it to your tax return
If the forgiven debt does not qualify under the provisions of the MFDRA, you still may be able to avoid paying taxes on the sale by filing for bankruptcy or insolvency. Those processes require significant planning, and should not be done without the help of an attorney.