The Responsibility of Taxes After a Foreclosure

A foreclosure is essentially a financial rock bottom. It occurs when a homeowner is unable or unwilling to pay the amounts due on his mortgage. Many mortgages are structured so that tax payments are made by the mortgage company and the tax payments are included in the mortgage payment. So, if a homeowner is not making mortgage payments, the tax payments may not be made as well. Foreclosures and changes of ownership do not stop taxes from being collected, but the responsibility will change as the situation develops.

Foreclosure

Foreclosure is the legal process that occurs when a homeowner is extremely delinquent on his house payments (approximately three months, but it depends on state law) and the bank repossesses the house in exchange for discharging the amount owed on the mortgage. There are serious credit consequences to this process and the homeowner will be generally barred from purchasing another home for five to seven years, unless there were extenuating circumstances, which reduces the waiting period to three to seven years. The waiting period will be determined on a fact-by-fact basis.

Who Pays Taxes After a Foreclosure?

The responsibility of property taxes always falls on the owner of the property. As such, after a foreclosure, there has been a change in ownership and the new owner would be responsible for any taxes owed on the property. Typically, when a house has gone into foreclosure, taxes on the home and property are also delinquent and there may be liens on the house and property. As the new owner of the house and property, the bank that forecloses on the property will pay the delinquent taxes to clear the title.

Discharge of Debt

When a house is foreclosed upon, the IRS views that as a discharge of debt. Under the federal tax code, a discharge of debt is counted as income. Accordingly, the taxpayer receiving a discharge of debt will be required to pay income taxes on the amount discharged. There are, however, ways to avoid this income tax -- one of which is to prove you are insolvent. Congress passed the Mortgage Forgiveness Debt Relief Act of 2007 to exclude from income the debt forgiven on a mortgage through foreclosure during 2007 to 2012, rather than requiring the forgiven amount to be treated as taxable income.

Disposition of Home

The federal tax code provides for homeowners to exclude from income up to $250,000 for single taxpayers or $500,000 for married couples filing jointly upon the sale of their home provided the home has been used as the primary residence for at least two years. This exclusion represents the amount in excess of the amount paid for the house, which is called the basis. Since foreclosures are often treated as a disposition of property, if the fair market value of the property has increased as of the time of the foreclosure, the gain could be excluded if it does not exceed the statutory limits.

References

• The New York Times: After Foreclosure, a Big Tax Bill From the I.R.S.
• Internal Revenue Service: Home Foreclosure and Debt Cancellation
• Foreclosure University: What Is Foreclosure?
• Fannie Mae: Underwriting Borrowers With a Prior Foreclosure
• Internal Revenue Service: The Mortgage Forgiveness Debt Relief Act and Debt Cancellation