It has become common for the media to report that foreclosures on real estate are ever increasing. The tax consequences of a foreclosure can be an unpleasant surprise.

A foreclosure sale, an abandonment of the property or a deed to the mortgage holder (a “deed in lieu”) are treated as a sale of the property for tax purposes. While these events are legally distinct, they can be collectively referred to as a foreclosure.

Generally, a sale of a capital asset, such as real property, is taxed on the difference between the amount realized on the sale minus the owner’s adjusted (tax) basis. The owner’s adjusted basis is the amount paid for the property plus any capitalized items, including improvements, minus any depreciation taken.

The tax code’s rules defining the amount realized from a foreclosure bring about the complexity with a foreclosure.

Fair Market Value

The critical factor in determining the tax consequences of a foreclosure is the property’s fair market value.

If the fair market value of the property is more than the principal amount of the debt, a foreclosure will lead to a taxable gain. The amount realized is the fair market value of the property. If the property is sold at a foreclosure sale, the sales price is presumed to be fair market value. The price bid by the mortgage holder (the “mortgagee”) does not control the tax consequences of the sale.

If the property is the owner’s personal residence, the taxability of the gain is determined by following the rules for the sale of a personal residence. Those rules hold that if the owner had lived in the property for more than two out of the last five years and had a gain of $250,000 or less ($500,000 if the owner is married and filing jointly), the gain will not be taxed. For business or investment property, the gain will generally be taxed as a capital gain. In those circumstances where the owner has claimed accelerated depreciation, ordinary income may arise from the recapture of the accelerated depreciation.

When the fair market value of the property is less than the principal amount of the debt, the tax code bifurcates the sales proceeds. The amount realized is considered the fair market value of the property. The loss on the foreclosure is calculated by the difference between the owner’s adjusted basis and the property’s fair market value. With a personal residence, a loss is not deductible.

The difference between the fair market value of the property and the principal amount of the debt is treated as ordinary income. The tax code treats the cancellation or the forgiveness of indebtedness as ordinary income – often referred to as cancellation of indebtedness income, or COD income. COD income is not excluded under the general rules, which make most sales of personal residence tax free to the homeowner. This unexpected result often causes great unhappiness for the owner whose property has been foreclosed upon. The following example may be of assistance in calculating COD income: Assume a home was purchased for $300,000. The owner paid $50,000 in cash and took a mortgage for $250,000. The property is foreclosed upon when the mortgage balance has been reduced to $240,000 and the fair market value of the home is $200,000. The homeowner has COD income in the amount of $40,000, the difference between the fair market value of $200,000 and the principal of the mortgage of $240,000. With a personal residence the loss of $60,000 ($300,000 adjusted basis minus the $240,000 mortgage balance) is without tax consequence. With a business or investment property, a capital or ordinary loss would usually occur.

Right of Redemption

If the owner has the right of redemption of the property, the foreclosure is not complete until the time for the redemption has passed. The owner may wish to release his right of redemption if the reporting of the tax consequences of the foreclosure is more favorable in an earlier tax year than a later year.

An abandonment of property is reported in the year of the abandonment.

If the amount received by the mortgagee is less than the principal amount of the debt, the mortgagee can commence an action against the owner for the shortfall. Massachusetts, General Law Chapter 244, Section 17A holds that this time period is two years after the date of the foreclosure.

The uncertainty caused by the mortgagee’s right to commence an action for any shortfall (commonly referred to as a deficiency) delays the determination on the issue of whether the shortfall has been forgiven by the mortgagee. If the mortgagee does not commence an action, the COD income must be reported in the year that the mortgagee’s right to bring an action expires. If the mortgagee does bring an action, the cancellation does not occur until the mortgagee’s right to collect on the shortfall expires.

Mortgagees who forgive debt are required to send Form 1099-C, Cancellation of Debt, to the owner and the Internal Revenue Service. That form reports the amount of debt forgiven. The failure by the mortgagee to send the form does not free the owner from the responsibility to report the cancellation of the debt to the IRS.

Exceptions to COD Income

Internal Revenue Code Section 108 provides exclusion from income for the cancellation of debt when owners are insolvent or have debt discharged through bankruptcy proceedings.

If a debt is forgiven or discharged during a bankruptcy proceeding, COD income is excluded from the owner’s income. This exclusion was commonly used prior to the Bankruptcy Abuse Prevention Act of 2005. It is widely believed that the changes in the Bankruptcy Code will make the bankruptcy exclusion for COD income less available.

IRC Section108 also provides an exclusion of COD income for debt forgiveness if the owner is insolvent at the time that the debt is cancelled.

The Internal Revenue Code’s definition of insolvency is more stringent than the Bankruptcy Code’s. To be insolvent a taxpayer must have liabilities in excess of the fair market value of assets. The insolvency calculation is to be made on the basis of the owner’s assets and liabilities immediately before the forgiveness.

The insolvency exception is limited to the amount by which the owner is insolvent. If after the foreclosure the fair market value of the owner’s assets exceeds liabilities, COD income is realized on that amount (limited to the amount of debt that was forgiven).

Often, owners have liabilities, such as personal guarantees, which are contingent. If the liabilities are to be included in the calculation to determine whether the owner is insolvent, the owner must be able to prove that it is more probable than not that the owner will be called on to pay the obligation.

If proceeds from the foreclosure are used to pay interest and real property tax arrearages, the owner is allowed to claim those payments as tax deductions.

A foreclosure brings with it the possibility of an unfavorable tax consequence. Relief may be available under IRC Section 108. To take advantage of that section, it is strongly advised that records of the owner’s financial status at the time of the foreclosure and at the time of the cancellation of the debt be maintained.