Tax Considerations for Principal Residence Foreclosures Today
Despite the COVID-19 crisis, residential real estate prices generally remain stable or are even rising in many areas. Even so, pandemic-related financial stress may cause some homeowners to be unable to make their mortgage payments. Here are the range of federal income tax consequences that might happen if a lender eventually forecloses on a principal residence.
A foreclosure occurs when a mortgage borrower defaults and the lender takes over the mortgaged property in order to sell it before things get worse. When there are several mortgages against a property, any of the lenders can potentially initiate foreclosure proceedings. However, first mortgage lenders generally must be paid in full before second mortgage lenders can collect anything.
Important: Federal COVID-19 relief measures may temporarily postpone lender foreclosure actions for loans backed by government agencies. And some lenders may voluntarily postpone foreclosure actions. However, unless borrowers can regain the ability to make their mortgage payments, foreclosures will eventually happen.
The two most important variables in determining the federal income tax consequences of a principal residence foreclosure are:
1. Whether the mortgage is recourse or nonrecourse, and
2. The value of the property in comparison to the mortgage balance.
If your mortgage is a recourse mortgage, a foreclosure transaction isn't necessarily the end of the story. With these types of loans, the lender can pursue you for any deficiency, meaning any shortfall between the foreclosure sale proceeds and the loan balance plus foreclosure costs. It can take many months or even several years for a lender to decide whether to pursue you for the full deficiency, forgive part of it, or forgive the whole amount.
When the home is worth less than the outstanding recourse loan balance, the federal income tax rules treat the foreclosure as a sale of the property for its fair market value (FMV). So, the foreclosure triggers a tax gain if the FMV of the home exceeds its basis (basis usually equals the purchase price plus the cost of improvements).
However, the gain will often be free from federal income tax, thanks to the principal residence gain exclusion break. That break potentially allows unmarried homeowners to exclude from taxable income gains of up to $250,000. The maximum exclusion for married people filing joint federal income tax returns is $500,000.
To qualify for the gain exclusion break, you generally must have:
- Owned the home for at least two years during the five-year period ending on the foreclosure date, and
- Used the home as your principal residence for at least two years during that five-year period.
If the basis of a principal residence exceeds FMV, the foreclosure transaction will trigger a nondeductible loss.
If the lender then forgives all or part of the deficiency, the forgiven amount constitutes cancellation of debt (COD) income for federal income tax purposes. Any COD income must be reported as income on your personal return for the year the debt forgiveness occurs, unless you qualify for a tax-law exception.
On the flipside, when the home is worth more than the outstanding recourse loan balance, the federal income tax rules treat the foreclosure as a sale of the property for a price equal to the loan balance, plus any additional proceeds the borrower receives from the foreclosure sale.
The situation is different with a nonrecourse mortgage. Here, the lender's only remedy is to take the property and sell it. If there's a deficiency, the lender can't go after the borrower to recover the deficiency.
A foreclosure by a nonrecourse lender is treated for federal income tax purposes as a sale of the property to the lender for an amount equal to the nonrecourse mortgage balance. The property's FMV is irrelevant in the context of the federal income tax results.
With nonrecourse mortgages, there's never any debt forgiveness, because the taking of the property in foreclosure is deemed to completely satisfy the nonrecourse loan. Therefore, there's no possibility of taxable cancellation of debt (COD) income with a nonrecourse mortgage foreclosure. However, there will be a tax gain or loss from the deemed sale to the lender.
A tax gain occurs if the nonrecourse loan balance exceeds the property's basis (usually the original purchase price plus the cost of any improvements). The gain will often be free from federal income tax, thanks to the principal residence gain exclusion break.
Conversely, a nondeductible tax loss is triggered if the property's basis exceeds the nonrecourse loan balance.
Tax Rules for COD Income from Recourse Mortgage Foreclosures
The general rule is that any cancellation of debt (COD) from a forgiven principal residence recourse mortgage must be reported as income on the borrower's personal tax return for the year the debt forgiveness occurs. However, there are three key tax-law exceptions to the general rule:
1. Principal residence mortgage debt exception. Through 2020, COD income from up to $2 million of forgiven principal residence acquisition debt is federal-income-tax-free. However, this exception doesn't apply to a second mortgage or home equity line of credit if the loan proceeds weren't used to acquire or improve your principal residence. It's uncertain whether this break will be extended beyond the end of this year.
2. Bankruptcy exception. If mortgage debt is forgiven in a Title 11 bankruptcy proceeding, the resulting COD income is free from federal income tax.
3. Insolvency exception. If the borrower is insolvent (debts in excess of assets) when the mortgage debt forgiveness occurs, the resulting COD income is federal-income-tax-free if the borrower is still insolvent after the debt forgiveness. If the debt forgiveness causes the borrower to become solvent, the resulting COD income is taxable to the extent the debt forgiveness causes solvency.
For More Information
COVID-19-related financial distress will probably result in a greater number of principal residence foreclosures. If you have questions or want more information about the federal income tax implications of a principal residence foreclosure action, consult Kevin.