The Tax Problems You Get From Turning Your House Back to the Bank

A deed in lieu of foreclosure helps you avoid some tax issues when transferring property.

Normally there would be serious tax consequences for surrendering a house and thus having a mortgage loan canceled. The Internal Revenue Service (IRS) considers the unpaid portion of the debt, over and above the value of the property, as forgiven debt and thus taxable income. With the mortgage crisis, however, the federal government changed the rules for taxation of forgiven debt in 2007, to the advantage of borrowers in distress.

Deed in Lieu of Foreclosure

When a mortgage loan is "non-performing" (going unpaid), one common method for a borrower to surrender a property to a lender is known as a "deed in lieu of foreclosure." This allows the borrow, and the lender, to avoid the default and foreclosure process. State laws will also require the borrower to sign a quitclaim deed and/or warranty deed.

Voluntary Basis

The borrower and lender must enter into the deed in lieu of foreclosure on a voluntary basis. In the agreement, the property must be assigned its fair market value. The outstanding loan amount may or may not exceed the current market value of the property.

Cancellation

The lender considers the loan canceled and waives its right to claim the unpaid portion of the debt. The borrower must quit the property by an agreed-upon date, but there is no eviction process.

Fees

The borrower may need to pay a state deed tax, and other document taxes, to process the deed in lieu of foreclosure.

Tax Relief

For income tax purposes, the borrower would normally owe tax on the difference between the fair market value of the property and the outstanding balance of the mortgage, plus any liens that were removed from the property. By the Mortgage Debt Relief Act of 2007, however, this tax is waived for debts that are forgiven on mortgages securing principal residences. This applies to debts canceled in calendar years 2007 through 2012, up to $2 million for income tax filers who file joint returns, and up to $1 million for single filers.

References

• IRS.gov: The Mortgage Forgiveness Debt Relief Act and Debt Cancellation
• Mortgage Forgiveness Debt Relief Act