Tax Consequences of Foreclosures

by Milandria King, LL.M of

Cordell & Cordell, PC

As most separated and divorced men come to realize, it is often a daunting effort to maintain two households simultaneously.

When a man is responsible for maintaining the marital home in addition to procuring his own residence, if he is no longer residing in the marital home, this may soon present overwhelming financial obligations. Many homeowners in  jurisdictions around the country 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. Separated and divorced men are exceptionally vulnerable. What are the tax consequences of foreclosure?

 

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. Borrowers are generally shocked and upset that they now must pay income taxes on this same amount that they were not in a position to afford under the loan terms.
There are, however, several instances where cancellation of debt income is not taxable. The most common situations involve 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 as this combination would have a truly devastating effect on the separated or divorced man’s credit and FICO scores.

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

Another component of the home foreclosure scenario is capital gain income. Under the tax code,  a home foreclosure is treated like a sale, therefore, capital gain income is recognized if the property’s fair market value exceeds its basis (i.e., cost of the property). 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.    

Prior to pursuing any of the above-referenced strategies for overcoming a foreclosure, you should consult with a qualified tax attorney or C.P.A. in order to determine the appropriateness for your situation.
 

Milandria King is a Senior Attorney in the Memphis, Tennessee office for Cordell & Cordell, P.C., admitted to practice law in the state of Tennessee. Additionally, Ms. King is admitted to practice before the Sixth Circuit Court of Appeals and before the United States District Court for the Western District of Tennessee. Her memberships include the American Bar Association, the Memphis Bar Association, the Tennessee Bar Association, as well as the Association for Women Attorneys.

Read more about Ms. King.

 

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