Foreclosure's costly tax implications

I just wrote a story on foreclosures and taxes for Bankrate (you can read it here). It's an issue that's getting a lot of coverage of late, and deservedly so.

In doing the story, I talked to a lot of folks, lenders and tax experts, read IRS publications, struggled through worksheet calculations and even dug out our own current mortgage documents to double check what our loan committed us to.

It soon became clear how so many folks find themselves in trouble, like some of my neighbors.

Even under the best circumstances, buying a home is a complicated and confusing process. Add in, to borrow a phrase, the irrational exuberance of lenders and borrowers in the last few years, and it's easy to see how a lot of people got in over their heads and are now facing foreclosures and surprising tax bills.

Experience isn't always a guarantee: The hubby and I are in our fifth house. In addition to those five purchase mortgages, we refinanced a couple of them over the years, as well as got an equity line of credit, making us privy to eight home-related financial transactions. Most were fixed rate loans (except for the HELOC, which we used sparingly and paid off ASAP each time).

When we bought our Florida house, though, we took out a balloon mortgage. And by we, I mean me.  At that time, we needed a "jumbo" loan (back then, that meant something in the $200,000s) and the bank was offering a much lower rate if we did the 7/23 deal. The hubby, always and forever a 30-year-fixed man (part of the reason I love him is that steadfastness!), didn't like the idea, but as keeper of the checkbook and payer of monthly bills, I prevailed.

I didn't necessarily buy the pitch fully, but was persuaded in part by the words of the lender: "It's not a big deal. You've got plenty of time to redo the loan."

The lender, of course, didn't elaborate on the possibility that if we held the original loan, after seven years we would have to pay the mortgage balance in full or redo our loan on whatever terms were available then. But we knew it. And we thought about it all the time.

Luckily for us, soon after we got in that house, mortgage rates started -- and kept -- dropping. In a couple of years, we did indeed convert that loan to a comparable fixed rate -- now that I think about it, I guess that then puts our official mortgage count at nine -- and I, as instigator of this mortgage adventure, finally got a good night's sleep.

As I said, we were lucky. And we were somewhat experienced. And if worse had come to worst, we could have paid off the mortgage (or most of it if the stock market didn't tank). Today, a lot of folks have gotten into the housing market via ill-advised financing and no background to fully assess possible mortgage pitfalls.

I know, and agree, that a buyer has the responsibility to be well-informed. But even for experienced and informed home buyers, it's a financial jungle out there. And once you're in the house, life sometimes takes unexpected and unhappy detours, turning your dream home into the biggest nightmare ever.

Taxes, but no house: Losing your house is bad enough. Owing Uncle Sam money in connection with your now-gone abode is the epitome of insult to injury.

By now, folks are getting wise to the forgiveness of debit issue. It was covered by the New York Times last week, too, as well as in my story.

But there's also the possibility that you could realize a taxable capital gain on a foreclosure. Yep, it's true. Check out IRS Pub. 544, which says, in part:

If you do not make payments you owe on a loan secured by property, the lender may foreclose on the loan or repossess the property. The foreclosure or repossession is treated as a sale or exchange from which you may realize gain or loss.  ... You figure and report gain or loss from a foreclosure or repossession in the same way as gain or loss from a sale or exchange. The gain or loss is the difference between your adjusted basis in the transferred property and the amount realized.

There's one of those worksheets I mentioned earlier to help you come up with the bad tax news. I also offer some examples in my story.

The point is, foreclosure doesn't necessarily end your homeownership troubles. It could, in fact, add to them.

Possible Congressional help: As for taxes on foreclosures, there might be some legislative relief from D.C. on the way.

Back in April, Rep. Robert E. Andrews, D-N.J., introduced the Mortgage Cancellation Tax Relief Act of 2007 (HR 1876). On the other side of Capitol Hill, Sen. Debbie Stabenow, D-Mich., introduced an identical version, S. 1394. Both measures would amend the tax code to make debt forgiveness on principal home mortgages nontaxable income.

Since the bills were introduced back in the spring, they have been languishing. No hearings, nothing, by either the Ways and Means or the Senate Finance committees.

But given what's going on, and likely to keep going on for a while, with mortgages and unexpected taxes, that might soon change.

Comments

[Yikes]

What about IRS Form 1082 for basis adjustment of discharged debts. This seems to give people an out?

Thank you

[deepak taxes relief]

While computing the annual income tax, taxpayers can offset the amount of tax relief granted against the income tax that they owe to the government. Similar to personal tax allowance, tax relief for employees is offered throughout the year. Tax relief is normally placed under various categories as tax relief for employees, self-employed people, training and educational institutions, property, medical and insurance premiums, and payments to charitable institutions.

[dimes]

I'm glad to finally be seeing some info about this stuff, because it is SO confusing. I really hope the law making mortgage forgiveness nontaxable income is NOT passed, because a lot of the people who would benefit will be undeserving (like Casey Serin and other failed flippers).

[Jeff Day]

Don't really understand the post about the foreclosure and forgiveness of debt issue being a big deal in of itself.

Since a foreclosure is the sale of a residence, if the folks lived in the house 2 of the last 5 yrs there is no tax on any gain, and in reality what is the likliehood of a gain since the housing market went down?

But then in a similar situation, have a client whose house was "sold" in a tax sale. They were delinquent aproximately $2000 in taxes, They paid off the firm that "bought" the house over $6000. And that was in less than 6 months. My question is, no 1098 was issued, do you feel they are entitled take a deduction for the actual amount of interest paid?

The tax sale was in November of '06. The payment was made in February '07. So were the taxes paid in '06 or in '07? I maintain they were paid in '06 since the sale was made and taxes paid.