For the first time in more than 13 years, we are seeing an increasing number of homeowners lose their homes in foreclosure. In fact, as recently reported in the North County Times, California led the nation in total foreclosure filings during the last quarter, showing as many as one filing for every 88 households. On top of all the financial stresses hitting you if you are going through this, there are some complicated tax consequences to deal with.
Essentially, a foreclosure is treated as a sale for tax purposes. Usually, a 1099 form will be issued to you and reported to the IRS, showing the gross proceeds of the sale. There is also an escrow closing statement produced, which shows the total value for which the house was transferred to the lender. This closing statement typically includes the unpaid taxes and interest that have accrued, as well as the principal balance of the loan at the point of transfer.
As the seller, you would generally total all of these “credits” and report this amount as the sales price of your property.
The immediate concern is to determine if there is a taxable gain. Even though the rules relating to the sale of a personal residence were changed in 1997, many taxpayers are not aware of how to apply these rules. As it stands, it is no longer necessary to buy another home or be older than 55 to exclude a gain. The crucial issue is that you need to own and live in your home for two out of the previous five years.
However, even this two-year rule can be bent a little if you are selling because of a job change or if you have other unusual circumstances. Since losing the financial ability to maintain a property has been found to be such an unusual circumstance, homeowners who lose their homes to foreclosure should be able to exclude up to $500,000 in gain if married and $250,000 if single.
Sadly, capital losses resulting from the sale of your home are not deductible.
Unfortunately, in an environment of rising home prices and frequent refinancing, it is possible to have a gain from foreclosure that far exceeds the excludible gains discussed above —- $500,000 is not as much as it once was, and the limits have not been adjusted for inflation. To make sure you don’t pay unnecessary taxes when you sell, it is important for you to keep track of the “basis,” which is, generally the cost of your home. This would include the initial purchase price and all of the improvements during the time that the home is owned. If the original purchase followed a gain on a previous home that was deferred under pre-1997 rules, this will further lower your basis and increase the potential gain.
There could be a surprising tax benefit to having your home foreclosed upon.If you are in this fix, you have probably stopped paying interest and property taxes for a while. During foreclosure, these expenses that have been deferred end up being paid by the lender. The strange result is that even though you lose your home and have not been paying the taxes or interest in cash, you may still be able to claim these items as itemized deductions.Instead of going the foreclosure route, you may be considering a “short sale” to save your credit. This is discussed in another article that is also posted.