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The Tax Consequences of Foreclosure
by Mark Minassian, CPA

The tax consequences of foreclosure can be like a kick in stomach after losing your property. Getting a letter from the IRS saying that you owe back taxes on your foreclosure will make you miserable. If foreclosure is inevitable, it is of utmost important that you understand the potential tax consequences.

Example

You purchased an investment property for $200,000 three years ago and put 5% ($10,000) down with an interest-only mortgage of $190,000. Meanwhile, you have claimed depreciation deductions of $7,273 in each year (i.e. years one, two and three) that you have owned the property. At the end of year three, your adjusted cost basis in the property is $178,181 ($200,000 original cost - $21,819 of three years cumulative depreciation = $178,181).

Now you have hit tough times. You can’t find any tenants for your property and you can’t afford the make the mortgage payments because there is no rental income coming in. To make matters worse, with the sluggish real estate market, the value of your property has dropped to $180,000. Since you have stopped making mortgage payments, your lender has foreclosed and taken the property.

The Tax Consequences

When the lender takes your property, for tax purposes it is treated as if you sold the property to the lender for the lesser of its FMV at the time of foreclosure or the outstanding mortgage on the property. If the FMV of the property is less than the mortgage (as is the case in our example) and the lender forgives the difference between the FMV and outstanding mortgage, that difference is treated as debt-discharge income to you. So in our example, assuming the lender forgives the difference, you would have debt-discharge income of $10,000 ($190,000 outstanding mortgage - $180,000 FMV of the property = $10,000 debt discharge income). However, if you are in bankruptcy or insolvent at the time of foreclosure, you will not have to recognize the debt-discharge income.

But here’s where it can get worse. The FMV of the property is determined by the bid price at the foreclosure auction. So if someone buys the property for $170,000 at auction, your debt discharge income increases to $20,000 ($190,000 outstanding mortgage - $170,000 FMV of the property = $20,000 debt discharge income).

TIP: Often times the only bid on the property at auction will be from the lender, and the bid will be very low (sometimes even $1). If this is the case, you have a right to prove that the FMV of the property is higher than the lender’s bid. A qualified appraisal of the property is the best way to prove the property’s FMV.

Finally, if the FMV of the property is greater than your adjusted basis in the property, you will have a capital gain. If it’s less, you will have a capital loss. So in our example, if the property did fetch $180,000 at auction, your capital gain on the foreclosure would be $1,819 ($180,000 FMV - $178,181 adjusted basis = $1,819 capital gain). If the property sold for $170,000, your capital loss would be $8,181 ($170,000 FMV - $178,181 adjusted basis = -$8,181 capital loss).

As you can see, the tax consequences of foreclosure can be nasty. It is possible to lose your property, have debt-discharge income and have capital gain income upon the sale of your property at auction. And while foreclosure is the last option, it is becoming more and more a reality for many investment property owners. If you ever get to that point, consult a good attorney and CPA so you understand what type of financial and tax consequences you may face when your property is foreclosed upon.

Disclaimer:  Any tax advice contained in this article is not intended or written to be used, and cannot be used, to avoid penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions.

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