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.
Example 1: Cliff's principal residence is burdened by a $300,000 first mortgage and a $100,000 home equity loan (second mortgage). Cliff is current on the first but has stopped paying the second. The second mortgage lender can initiate foreclosure proceedings even though Cliff is still current on the first mortgage.
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.
Quick Summary of Tax Rules for COD Income from Principal Residence Recourse Mortgage Foreclosures
The general rule is that any cancellation of debt (COD) from a forgiven principal residence recourse mortgage balance must be reported as income on the borrower's Form 1040 for the year the debt forgiveness occurs. However, Section 108 of the Internal Revenue Code provides several exceptions to the general rule. Here are the three most important exceptions in the context of principal residence foreclosures.
Bankruptcy Exception: If the borrower is in bankruptcy when the debt forgiveness occurs, any COD income is federal-income-tax-free.
Insolvency Exception: If the borrower is insolvent (debts in excess of assets) when the debt forgiveness occurs, the COD income is federal-income-tax-free as long as the borrower is still insolvent the debt forgiveness. If the debt forgiveness causes the borrower to become solvent, the COD income is taxable to the extent the debt forgiveness causes solvency.
Principal Residence Mortgage Debt Exception: Through 2012, COD income from up to $2 million of principal residence acquisition debt forgiveness is federal-income-tax-free. However, his exception does not apply to a second mortgage or HELOC if the loan proceeds are not used to acquire or improve your principal residence.
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.)
Example 2: Teri has a $360,000 recourse first mortgage and a $200,000 recourse second mortgage. When Teri stopped paying the second, the lender foreclosed. Assume the home has a $500,000 FMV and a basis of $420,000. In the foreclosure sale, the first mortgage is completely paid off along with $140,000 of the second. Teri scrapes up $10,000 to pay off part of the $60,000 remaining second mortgage balance, and the lender forgives the last $50,000.
The foreclosure triggers an $80,000 gain ($500,000 FMV - $420,000 basis = $80,000). If Teri qualifies, the gain can be excluded under the home sale gain exclusion break.
The $50,000 forgiven by the second mortgage lender constitutes COD income. Teri must report the $50,000 as income on her return unless she qualifies for a tax-law exception.
Note: If the second mortgage lender pursues Teri for the $50,000 deficiency, there is no COD income unless and until the lender forgives some or all of the deficiency. Until that happens, there is nothing to report on Teri's tax returns with respect to the deficiency.
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.