The Tax Guy: Tax Consequences of Home Mortgage Foreclosure

The Tax Guy

Many homeowners around the Valley are falling behind in their mortgage payments, in large part due to adjustable rate mortgages (ARMs) that have reset to higher rates. The delinquency rate for mortgage borrowers continues to increase, and a record number of homes are entering the foreclosure process.

The tax consequences that accompany a home mortgage foreclosure can further weaken an already tenuous financial condition. When a lender forgives any portion of a mortgage loan, taxable "cancellation of debt" income generally results. The lender will then issue the borrower a 1099-C for the loan amount forgiven. Clients are generally shocked and upset that they now must pay income taxes on this same amount that couldn’t pay for in the first place.

However, there are several instances where cancellation of debt income is not taxable, the most common involving bankruptcy, insolvency, qualifying farm debts and non-recourse loans. It should be noted that most homeowners whose homes are foreclosed do not also file for bankruptcy (this decision should be discussed individually with a financial advisor to determine its appropriateness). 

A taxpayer that owes additional tax due to a home mortgage foreclosure can request a payment agreement with the IRS, or may qualify to enter into an offer-in-compromise (OIC) that will provide a partial abatement of the tax. This process can be lengthy but may be well worth the effort (Note: During the past 2 years, the IRS has substantially tightened the qualifying conditions for OICs). 

Another component of the home foreclosure scenario is capital gain income. Because a home foreclosure is treated like a sale, capital gain is recognized if the property's fair market value exceeds its basis. However, a taxpayer may exclude up to $250,000 ($500,000 for joint filers) of this gain if the property was owned and used as a principal residence for two of the previous five years.

If the home was held as a rental property the gain will be taxed at rates determined by the holding period of the seller. As a rental property, the seller will also be entitled to take any capital losses from the sale to offset other capital gains or offset ordinary and wage income up to $3,000 a year carried forward until the capital loss is spent.   

Jermaine A. Southern a.k.a. "The Tax Guy" is a Certified Public Accountant (CPA) living in Phoenix, Arizona. He received his B.A. in Accounting from Morehouse College, and graduated from Arizona State University's W.P. Carey School of Business with a Masters of Taxation. He has been in public practice for more than nine years along the way working at both international (Deloitte & Touche LLP) and regional (Clifton Gunderson LLP) firms. He is now principal of his own private practice. The Tax Guy's articles do not necessarily reflect the views of PhxSoul.com. Please visit southerncpafirm.com to reach Jermaine for additional questions with regard to this article or other tax assistance.

Comments

[John Beck]

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[Jules Carney]

I do not ordinarily allow for points out on posts that I read, but I precious to tell you that you have a very nice spelling fashion.
It is nice to see someone that be able to crack such a tricky topic down and make it easy to understand.

Thanks for sharing

[Tax Guy]

ALSO REMEMBER THAT THE MORTGAGE FORGIVENESS IS ONLY AVAILABLE ON YOUR PRIMARY RESIDENCE, INVESTMENT PROPERTIES WILL NOT QUALIFY!!!

[Tax Guy]

FHA Mortgage Refinance,

You are correct, this has also changed for short sales too. I referenced this change in my last post on the Economic Stimulus Package.

[FHA Mortgage Refinance]

Jermaine,

Thank you for contributing this article. However, didn't the congress pass
Mortgage Forgiveness Debt Relief Act, info on it here: http://www.mortgage-foreclosure-litigation.com/congress-passes-bills-helping-home-owners-in-foreclosure/ which specifically took care of the tax issue of forgiven mortgages?