Unexpected Tax Bill Adds to the Pain of Foreclosure

By Benny L. Kass
Saturday, September 29, 2007

Foreclosures are up, and many families are losing their homes. That's bad enough, but the IRS has an unpleasant surprise for them: They may have to pay extra taxes, even though they didn't receive any money.

Most homeowners are completely unaware of an obscure provision in the tax code related to debt cancellation. Or they might think such matters apply only to corporations and high-income individuals, but this law applies to all taxpayers, regardless of income.

If you lose your home to foreclosure, both ordinary income and capital gains tax may be assessed against you.

Consider this example. You bought your home a couple of years ago for $170,000. Earlier this year, when your house was worth about $200,000, your lender foreclosed. Because you had not made mortgage payments for some time, your mortgage balance had increased to $220,000.

To determine if any tax is due, the IRS wants you to subtract the fair market value from the amount of your debt. In this case, that difference comes to $20,000. Unless you qualify for an exclusion, this $20,000 is taxable income and must be included on your tax return for the year.

But that's not the end. You then have to subtract your adjusted basis from the fair market value of the house. In our example, that difference is $30,000. (It should be noted that this analysis is the same as if you had sold your house for $200,000.) If you have owned and lived in the house for at least two years before the foreclosure, you can exclude up to $250,000 of profit, or up to $500,000 if you are married and file a joint tax return. Otherwise, the $30,000 is considered profit, and you will have to pay capital gains tax on that amount to the IRS and possibly to the state in which you live.

There are, however, two exclusions that may help. They apply if the discharge of the debt occurs in a Chapter 11 bankruptcy case or when the taxpayer is insolvent. If either is true, you will not have to pay money if you lose your house by foreclosure. In our example, if at the time of the foreclosure, you had other debts -- such as credit cards or car loans -- that exceeded your assets, you were considered insolvent and will not have to pay any tax.

If your home is foreclosed on, your lender must send you a year-end statement showing the amount of debt forgiven and the fair market value of the property at the time of foreclosure. Review this form, called a 1099-C, carefully. The value your lender places on your property is critical. As discussed above, the income tax you may have to pay is based on the difference between that value and the amount of your mortgage at the time of the foreclosure. So if you believe your home has been undervalued, make sure you obtain independent appraisals from real estate brokers or from your local government assessor. If the form contains errors, get in touch with your lender. If the lender agrees with you, you should receive a corrected form.

This is a highly complex and specialized area of tax law. Recognizing this, the Internal Revenue Service created a special section on IRS.gov for people who have lost their homes due to foreclosure.

There is only one item so far, "Questions and Answers on Home Foreclosure and Debt Cancellation," but that material is helpful and should be read by every homeowner who is falling behind ( http://www.irs.gov/newsroom/article/0,,id=174022,00.html).

Foreclosure should be the last resort. If you start missing your monthly mortgage payments, don't ignore this. You should immediately talk with your lender and see what options are available. Keep in mind that legitimate lenders do not want to foreclose on your home. Especially in today's market, where home sales are weak, the lender does not want to add your house to the rest of its inventory.

Additionally, the jurisdiction in which you live may have set up programs to give temporary relief for delinquent homeowners.

Perhaps the most important thing to do is to consult with financial advisers, who can help you determine whether you will have to pay any tax should you ultimately lose your house.

Benny L. Kass is a Washington lawyer. For a free copy of the booklet "A Guide to Settlement on Your New Home," send a self-addressed stamped envelope to Benny L. Kass, 1050 17th St. NW, Suite 1100, Washington, D.C. 20036. Readers may also send questions to him at that address or contact him through his Web site, http://www.kmklawyers.com.

© 2007 The Washington Post Company