A foreclosure occurs when a mortgage borrower defaults and the mortgage lender seizes the mortgaged property in order to sell it before things get worse.
More Than One Mortgage
When there are several mortgages against a property, any of the mortgage lenders can potentially initiate foreclosure proceedings. The first mortgage generally must be paid in full before the second mortgage lender can collect anything in a foreclosure.
Recourse versus Nonrecourse Mortgage
The foreclosure transaction is not necessarily the end of the story if your mortgage is a recourse loan, because the lender can pursue you for any negative difference (deficiency) between the foreclosure sale proceeds and the loan balance plus foreclosure costs. See Part 1 of our series for the story on recourse mortgages foreclosures.
In contrast, with a nonrecourse mortgage, the lender's only remedy is to foreclose on the property and sell it. If there's a deficiency, the lender cannot go after you to collect it.
In some states, first mortgages taken out to acquire principal residences are nonrecourse but second mortgages are recourse. In this scenario, the second mortgage lender can initiate foreclosure proceedings and pursue the borrower for any deficiency on the second, but the first mortgage lender cannot pursue the borrower for any deficiency on the first.
Tax Impact of Nonrecourse Mortgage Foreclosure
The most important variable in determining the federal income tax consequences of a principal residence foreclosure is whether the mortgage is recourse or nonrecourse. Here's the deal on nonrecourse mortgage foreclosures.
A foreclosure by a nonrecourse lender is treated for federal income tax purposes as a sale of the property to the lender for an amount equal to the nonrecourse mortgage balance. The property's FMV is completely irrelevant, and the lender cannot pursue the borrower for any deficiency. There's never any debt forgiveness, because the taking of the property in foreclosure is deemed to completely satisfy the nonrecourse loan. Therefore, there is no possibility of taxable cancellation of debt (COD) income with a nonrecourse mortgage foreclosure.
However, there will be a gain or loss from the deemed sale to the lender.
A gain occurs if the nonrecourse loan balance exceeds the property's basis (usually the original purchase price plus the cost of any improvements). The gain will often be federal-income-tax-free thanks to the home sale gain exclusion break. It allows an unmarried person to exclude (pay no tax on) a principal residence gain of up to $250,000; a married joint-filing couple can exclude up to $500,000. To qualify, you generally must have: (1) owned the home for at least two years during the five-year period ending on the foreclosure date and (2) used the home as your principal residence for at least two years during that five-year period.
If the property's basis exceeds the nonrecourse loan balance, the foreclosure triggers a nondeductible loss.
Example 1: Steve took out a nonrecourse first mortgage to acquire his principal residence. When local real estate prices were rising rapidly, he thought he made a real killing when he found a lender willing to give him a big nonrecourse HELOC. When Steve stopped paying on the HELOC, the lender foreclosed. At that time, the first mortgage balance was $175,000, and the HELOC balance was $100,000. The property's basis was only $180,000.
Under the aforementioned deemed sale treatment, the foreclosure triggers a $95,000 gain ($275,000 total nonrecourse debt balance - $180,000 basis = $95,000). Assume Steve qualifies to exclude the entire gain under the home sale gain exclusion break. That is the end of the story, because the mortgage lenders cannot come after him for any deficiency.
Example 2: Same basic facts, except now assume Steve's property is a vacation home. The $95,000 gain is a capital gain that cannot be excluded because the home sale gain exclusion break is only available for principal residences. Therefore, Steve will pay tax on the whole gain unless he has some offsetting capital losses. The good news is the mortgage lenders cannot come after him for any deficiency.
The Bottom Line
With a nonrecourse mortgage, the single most important thing to understand is that the lender cannot come after you for any deficiency after the foreclosure sale.
Tax-wise, the most important thing to understand is that a principal residence nonrecourse mortgage foreclosure can result in a gain. Thankfully, the gain will often be federal-income-tax-free thanks to the home sale gain exclusion break (state income tax results may vary).