Most people are shocked that they can lose their property and still owe taxes on the profit. We often hear people say that they prefer to be foreclosed since they will not owe any tax, but if they sell (and have no net sales proceeds) they will owe substantial tax. WRONG!
Just how much and what type of tax the IRS expects after a foreclosure depends in large part on whether the loan is of the recourse or nonrecourse variety.
The tax results of a foreclosure, deed in lieu of foreclosure, or short sale depend on the nature of the loan: whether it is recourse or non-recourse. Recourse means that the borrower has personal liability for the loan, in addition to the risk of losing his real property.
With a recourse loan, the debtor is personally liable for the debt. In a foreclosure, it means if the property sale proceeds are not enough to cover the outstanding mortgage, the debtor must pay the difference. This includes interest that accrues during the foreclosure process.
A nonrecourse debt, however, is secured by the loan collateral. If money from sale of the property doesn't cover the outstanding debt, the lender has no legal ability to get the additional funds from the debtor.
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Tax Analysis Examples: FORECLOSURE/SHORT SALE BROCHURE
1) Bob owes $100,000 on a property he bought for $130,000, now worth $80,000. If Bob is foreclosed, gives the property to the lender, or the lender accepts a short sale payoff, Bob is taxed as if he had sold the property for $100,000.
Bob's loss of $30,000 is not deductible if it is his residence, but is deductible if the property is a rental.
TAX TIP: If you expect a loss on your own home, move out, rent the property, and then the loss may be deductible since the property is a rental!
2) Sam owes $100,000 on a property he bought for $95,000, now worth $80,000. If he is foreclosed, gives the property to the lender, or the lender accepts a short sale payoff, Sam is taxed as if he had sold the property for $100,000.
Sam's profit of $5,000 is subject to the rules for sale of residences [2 year rollover & Over-55 Rule apply], or rental property, depending on Sam's use of the property.
3) Ted owes $100,000 on a property he bought for $95,000. At the foreclosure auction, it sells for $110,000. Ted is taxed as if he had sold the property for $110,000.
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Arina- very informative post (as usual :-D).
TAX TIP: If you expect a loss on your own home, move out, rent the property, and then the loss may be deductible since the property is a rental!
Is there any kind of time period that it has to be a rental for this to work? I am guessing there would be, theres rules to everything lol.
Arina: Interesting article, allot of useful information on the tax consequence. I have had several sellers want me to sell their home thinking they would just walk away with the debt occurred for the second and the first, the second was accumulated for personal toys and not improvements to the house. I was able to convince them to do everything they can in their power to continue to make the house payments on time and not get in default, I still have the house listed as a short sale, but they have continued to make payments on time.
Since you wrote this article have you been able to obtain current information regarding the brochure you have a link too?
I would have never thought about being able to for go debt if the house was able to be rented out, I will suggest on of my clients to talk to their accountant and see if they could rent out their home and rent another home. my only thoughts on this looking from the IRS point of view is:
In order to rent out a home for rent you must currently have a primary residence too, is there any follow up date on renting out your primary home to for go a debt?
My self I was able to deduct a certain amount on a home we sold and carried the second when 911 hit and the buyers business went in the toilet and he had to bail, he had things so upside down and the three attorneys I went to all gave me the wrong advice, I actually learned more and what I should have asked for since I have become a licensed agent.
Since we sold our primary home to relocate and buy another home even thou the house was not a rental I can write off $3,000.00 per year and or apply the whole loss to a sale of other income property I owe.
I have one short sale that would qualify if the rule still applies per you linked brochure. I will talk to my tax attorney and see if this still applies, when i find out more information I will do a post and let you know.