Tax Rules Compound Foreclosure Distress

Foreclosed Homeowners Can Be Taxed on Unpaid Debt

You might think that foreclosure and bankruptcy are just about the worst financial events in the world, but for those who lose their homes things can get even tougher. The problem? Tax rules from Uncle Sam say you can’t deduct losses from the sale of a personal residence. Even worse, unpaid mortgage balances may be regarded as income — taxable income.

Over the years tax write-offs have become substantially more restricted for most taxpayers. No longer can you write off interest for credit cards or auto loan interest, the amount you can deduct for student loans phases out as income rises and there are an endless assortment of limitations, restrictions and qualifications, and requirements for other write-offs.

Given the drift of tax policies, real estate write-offs often represent the average person’s best hope for major tax savings.

Property taxes are deductible for a prime residence and so is most mortgage interest. Even better, if you live in a residence for two of the past five years, sell the property and make money, then you can shelter up to $500,000 in sale profits if filing jointly and up to $250,000 if single.

All of this is great, except for those who face foreclosure:

Buried in the tax rules are two unusual provisions:

First, according to the IRS “you cannot deduct a loss from the sale of your main home.”

Second, unpaid mortgage debt can be regarded as taxable income.

“If the idea of tax policies is to raise income from the public then how much money can you possibly get from people who are flat broke?” asks Jim Saccacio, Chairman and CEO at, the nation’s largest source of foreclosure data. “If investors can write off real estate losses, why not ordinary homeowners? The losses for one are just as real as the losses for the other.”

Imagine that you buy a home for $300,000, live in it for two years and then sell for $400,000. You pocket $100,000 in profit but your federal tax bill is zero. Even better, there are no tax forms needed to claim such a write-off. “If you can exclude all of the gain,” says the IRS, “you do not need to report the sale on your tax return.”

But if you have a loss everything changes.

In basic terms there are two types of debt, recourse and nonrecourse financing. With recourse financing if you do not fully repay the debt a lender can potentially sue for any shortfall. In the case of a mortgage, that means the lender can foreclose and then go to court to get a judgment for any unpaid balance.

With nonrecourse financing, if a lender forecloses he is only entitled to the money which can be generated from the sale of the property. The borrower has no further liability.

In practice, when homes are sold at a foreclosure auction there is usually no lender effort to sue for any unpaid balance, though such a step may be possible. When a home is foreclosed in a court action, then a lender will frequently seek a deficiency judgment for any unpaid debt.

In addition to whatever actions might be taken or not taken by a lender, there is also another party with an interest in foreclosure matters: the government. Essentially the government wants to know if it’s owed any taxes, something which is possible in some cases even if a foreclosed home is sold at a loss.

The IRS — in Publication 544, Sales and Other Dispositions of Assets — gives examples showing how recourse and nonrecourse debt can be treated for tax purposes in a foreclosure:

Abena paid $200,000 for her home. She paid $15,000 down and borrowed the remaining $185,000 from a bank. Abena is not personally liable for the loan (nonrecourse debt), but pledges the house as security. The bank foreclosed on the loan because Abena stopped making payments. When the bank foreclosed on the loan, the balance due was $180,000, the fair market value of the house was $170,000, and Abena’s adjusted basis was $175,000 due to a casualty loss she had deducted. The amount Abena realized on the foreclosure is $180,000, the debt canceled by the foreclosure. She figures her gain or loss by comparing the amount realized ($180,000) with her adjusted basis ($175,000). She has a $5,000 realized gain.

Although Abena has a “gain” she would not usually pay a tax. Why? Because if she has lived in the home for two of the past five years, and if she files as a single taxpayer, then profits for as much as $250,000 can be sheltered.

Now let’s take the same sale situation and say that Abena has recourse debt. Here’s what the IRS says:

In this case, the amount she realizes is $170,000. This is the canceled debt ($180,000) up to the fair market value of the house ($170,000). Abena figures her gain or loss on the foreclosure by comparing the amount realized ($170,000) with her adjusted basis ($175,000). She has a $5,000 nondeductible loss. She also is treated as receiving ordinary income from cancellation of debt. That income is $10,000 ($180,000 – $170,000). This is the part of the canceled debt not included in the amount realized.

Abena must add $10,000 to her taxable income, income “created” by her cancellation of debt (COD). In other words, Abena is being taxed on debt she did not pay.

Logically there’s some sense to taxing COD income, but on a practical basis what’s really happening is that Abena and others who have been foreclosed can be taxed on “income” they don’t have in hand.

The good news is that there is now a movement in Congress to resolve this matter, to make foreclosure less painful.

Representatives Robert E. Andrews, D-N.J., and Ron Lewis R-Ky., are sponsoring H.R. 1876, a bill that would make mortgage losses on the sale of a personal residence tax deductible and bring some relief to many who have lost their homes.

Go back to the case with Abena. If the Andrews-Lewis measure passes the $10,000 in cancelled mortgage debt would not be regarded as taxable income.

“It seems entirely unfair to tax the phantom income of those who have been foreclosed,” says Saccacio. “Most people who lose their homes have simply run into hard times: they’ve lost a job, had an accident, gotten divorced or their spouse has passed away. To tax ‘income’ from foreclosure losses is pointless because the people can’t pay and the government can’t collect. It’s time to change the rules.”

For answers to tax questions about your real estate activities, whether profits or losses, be certain to see a CPA or other tax professional for specifics.

Peter G. Miller is the author of the Common-Sense Mortgage and is syndicated in more than 100 newspapers.

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