What Tax Penalties Are There If My House Was Foreclosed On?
A foreclosure does not just cause credit issues and lead to the loss of property, but it can also affect the taxes that you have to pay. In most cases the effect is minimal, and in the end you may not have to pay any more in tax. But the foreclosure sale does still count as a house sale and may lead to extra taxes depending on the situation. Canceled debt can create a similar issue.
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Gains and Losses
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A foreclosure sale still acts as a sale as far as the owner is concerned. However, this means that it can still create a gain or loss for you, even if all the money goes to paying off the loan. You will need to take the sale price for the foreclosure and compare it to the tax basis of the house, the value at which you bought it based on any changes that have occurred since then. If the foreclosure sale makes more than the house is worth according to the tax basis, you must record a gain, which will be taxed. If it is less, the sale can count as a loss.
Home Sale Gain Exclusion
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A primary reason you still have to pay on a gain, even if a foreclosure sale happens, is that the mortgage debt itself counts as money that you have received in the past, so in the view of the IRS, no loss has actually occurred unless it is a loss via market conditions. However, the IRS also makes room for a home sale gain exclusion, allowing you to deduct at least part of the gain received on the foreclosure, as long as it is for your primary residence and you have lived there for at least two years.
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Property Taxes
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Property taxes can be a tricky part of a foreclosure. If you are worried that you may need to pay them up through the foreclosure or even beyond, rest easy. This is one situation where the foreclosure can benefit you. The lender will typically ensure that property taxes are all paid before attempting the foreclosure. Even a tax lien foreclosure will pass the property tax debt on to the new borrower, so you will not be called up to pay taxes on property you no longer have.
Cancelled and Discharged Debt
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A foreclosure that sells for less than a mortgage will not fully pay off the debt, but the lender will often cancel any remained debt. This canceled debt will incur an income tax payment, but you may not have to pay it. If you qualify as insolvent (if you are in bankruptcy, for instance) you will not have to pay taxes on this forgiven debt. Also, the Mortgage Forgiveness Debt Relief Act of 2007 provided relief from this tax and applied to debts through 2012.
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