Foreclosure Basics

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. In contrast, with a nonrecourse mortgage, the lender's only remedy is to seize the property and sell it. If there's a deficiency, the lender cannot go after you to collect it.

Tax Impact of 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. I'll cover nonrecourse mortgage foreclosures in Part 2 of our series. Here's the story on recourse mortgage foreclosures.

Recourse Mortgage: Property Worth Less Than Loan Balance

When the property's fair market value (FMV) is less than the recourse mortgage balance (the most common situation), the tax rules treat the foreclosure as a sale of the property for the FMV amount.

So the foreclosure triggers a gain if the FMV of the home exceeds its basis (basis usually equals the purchase price plus the cost of improvements). However, 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 its FMV, the foreclosure will trigger a nondeductible loss.

If the lender then forgives part or all of the deficiency (the difference between the recourse mortgage debt and the foreclosure sales proceeds), the forgiven amount constitutes cancellation of debt (COD) income for tax purposes. Any COD income must be reported as income on your Form 1040 for the year the debt forgiveness occurs, unless you qualify for a tax-law exception. (See the sidebar.)

Recourse Mortgage: Property Worth More Than Loan Balance

When the property's FMV exceeds the recourse loan balance (a somewhat rare situation), the foreclosure is treated for federal income tax purposes as a sale of the property for a price equal to the loan balance plus any additional proceeds received by the borrower from the foreclosure sale.

The Bottom Line

The single most important thing to understand about a recourse mortgage foreclosure is that the lender can come after you for any deficiency that remains after the foreclosure sale. It can take many months or even several years for a lender to decide whether to pursue you for the full deficiency, forgive part of it, or forgive the whole thing.

Tax-wise, the most important thing to understand is that a principal residence recourse mortgage foreclosure can result in a gain and maybe some COD income too. Thankfully, any gain will often be federal-income-tax-free thanks to the home sale gain exclusion break (state tax results may vary). Some or all of any COD income may also be tax-free thanks to beneficial tax-law exceptions (see the sidebar). When no exception applies, COD income must be reported as income on your tax return for the year the debt forgiveness occurs.