Considered sale
When you lose your home to foreclosure, or the property is returned to the lender (Deed in Lieu of Foreclosure), a presumed sale or trade has been made under Section §1001 (a) of the Internal Revenue Code. This sale or exchange of property could result in a tax gain or loss, and the recognition of income from cancellation of debt (COD) for the taxpayer. The cancellation of the debt will result in taxable income for the taxpayer unless there is an exception within the statute (Section 108 of the IRC) that is beyond the scope of this article. An important factor that will determine the treatment for tax purposes is whether your loan is recourse or non-recourse.
Tax treatment of your foreclosure
When an asset is sold, the difference between the amount realized and the taxpayers’ “adjusted basis” on the asset will determine the amount of gain or loss recognized. The Realized Amount will be the property’s fair market value (FMV) or the face value of the debt, depending on whether the debt is classified as recourse or non-recourse. Consequently, if the debt has no recourse, the amount obtained will be the face value of the debt, which will generate more profits, but not the cancellation of the income from the debt. On the contrary, if the debt is to recourse, less profit is recognized, since instead the fair market value of the property is used at the date of sale, but there is the possibility of having to recognize income against reimbursement. This COD income will be the difference between the face value of the debt and the fair market value of the property.
Know the laws in your state Consumer Laws
The tax treatment of your home foreclosure will depend on whether your home loan was a recourse or non-recourse loan. Some states have laws that prevent banks from going after homeowners with unpaid loan balances, for primary residences, creating a non-recourse situation.
Recourse loan:
1 – The amount realized is the fair market value of the property.
2 – Adjusted basis is what you paid for the property or acquisition cost, plus capital improvements.
If the property was a rental, you must subtract the depreciation from the adjusted basis.
3 – The cancellation of the debt income is the difference between the fair market value and the nominal value of the debt.
4 – The profit or loss is the difference between the fair market value and the adjusted basis.
5 – Attribute reduction and / or deductible loss elimination must also be calculated due to any income exclusion of forgiven debt under IRC Section 108, due to debt cancellation, which is outside the scope of this Article.
Non-recourse loan
1 – The amount realized is the face value of the debt.
2 – Adjusted basis is what you paid for the property or acquisition cost as in (2) above.
3 – The cancellation of debt income is not a problem with recourse debt.
4 – The profit or loss is the difference between the nominal value of the debt and the adjusted basis.