Foreclosure & Federal Income Tax
Federal income taxes can be increased by a foreclosure. The foreclosure frequently involves the property owner making a deal with the bank to reduce the total amount paid. Since the property owner gains income by having debt forgiven, this can have tax consequences as a taxable gain of income.
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Foreclosure Gain
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The bank that originated the mortgage recorded the income from the principal and interest they expected to receive. After a foreclosure, they may write off part of this income as uncollectible. When the bank loaned out money for the mortgage, this was not considered income since the borrower had to pay principal and interest back to the bank. After a foreclosure, the bank repossesses the property, most likely recording it at a lower current value. The difference between the value remaining on the mortgage principal and the amount the bank records the repossessed house on its books is now considered taxable income.
IRS exemptions
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The IRS has some exceptions to the taxability of these gains. Gains from the bankruptcy process aren't considered taxable income. Of course, not every foreclosure involves filing for bankruptcy. According to the Harvard Law Blog, insolvency occurs either when a business can't pay its debts as they become due, or its debts exceed fair market value of its assets. Farmers also get an exemption. To be eligible for this exemption, the IRS requires that you incurred the debt to operate the farm, the majority of your income in the last three years was from farming, and the loan originated with a person or business that regularly makes loans.
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ARRA Section 108
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The American Recovery and Reinvestment Tax Act of 2009 (ARRA) addresses this issue. Section 108 is most pertinent to the topic of foreclosure and federal income tax. As part of an overall policy involving the Recovery Act, this law allows the deferment of income.
Why Deferment?
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Deferment allows income to be shifted from a year in which you received profit to one where you had a loss, reducing the total amount of taxes owed. Deferring the profit from cancellation of debt income is effectively a tax cut for the property owner.
Deferral Timeline
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A company may elect to defer some or all of the income under the ARRA. Debt cancellation income is deferred for five years if the debt reacquisition occurred in 2009, and for four years if it occurred in 2010. The income is then spread out over the next four years after the deferral period, 2014 through 2018.
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References
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