Tax Consequences on Foreclosed Homes



Tax Consequences on Foreclosed Homes 2012Britnee ColeyACCT 4611 Taxes for Business Decision Making Dr. Joseph M. Hagan11/15/2012-8953503549650Contents TOC \o "1-3" \h \z \u Introduction PAGEREF _Toc340727634 \h 3Recourse Debt and Nonrecourse Debt PAGEREF _Toc340727635 \h 4Foreclosures Being Treated as a Sale PAGEREF _Toc340727636 \h 4U.S. Policy Responses PAGEREF _Toc340727637 \h 5Ways to Avoid Foreclosure PAGEREF _Toc340727638 \h 5Short Sale PAGEREF _Toc340727639 \h 5Deed-in-lieu of foreclosure PAGEREF _Toc340727640 \h 6Forbearance PAGEREF _Toc340727642 \h 6Disadvantages of Short Sale and Deed-in lieu of foreclosure PAGEREF _Toc340727643 \h 6Bankruptcy PAGEREF _Toc340727644 \h 7Solvency PAGEREF _Toc340727645 \h 7Restrictions on Cancellation of Debt PAGEREF _Toc340727646 \h 8Conclusion PAGEREF _Toc340727647 \h 8Tax Consequences on Foreclosed HomesIntroductionOne of my co-workers came to work one day expressing how relieved she was now that the whole process of her home being foreclosed was all over. Even though she lost her home she always tried to look at the good side things. She kept saying over and over again how the pressure of coming up with tax money for her now foreclosed home this year was no longer an issue, or so she thought.People who homes have been foreclosed could be at risk of having to pay a tax on it. “If you thought a bank foreclosure ended the financial miseries associated with your former home, think again. You could soon be hearing from the IRS about taxes due in connection with the residence you no longer own” (Bell 1-4). The majority of people purchase homes through the bank by taking out a loan. Every month the purchaser pays the bank a portion of that loan back. When the purchasers can no longer make payments each month the home goes under foreclosure. Foreclosure is a form of cancellation of debt or debt forgiveness. What most people do not know is that cancellation of debt is part of taxable income and it will be taxed. I know you’re thinking how is that taxable income? Let me explain, the reason why they call it debt forgiveness is because the lender forgives you of some of the debt. For instance, “If the bank settles a $10,000 debt for you for fifty cents on the dollar then that means that you have $5,000 of debt forgiveness” (Les ). The Internal Revenue Service (IRS) counts this as income. That is the part of the loan that you did not have to pay which is $5,000 more dollars in your pocket that you otherwise would have had to pay; so it turns into income. When computing your tax cost, in sum it is just a tax base multiplied by a tax rate. The base for tax purposes is known as taxable income. To get taxable income you have to subtract any allowable deductions from gross income (Jones). Gross income to the Internal Revenue Code is defined as, “all income from whatever source derived.” That is how you will still have tax cost associated with your foreclosed home.Recourse Debt and Nonrecourse DebtBefore the IRS can tell you what the tax consequences are on the foreclosed home they first have to know whether the debt is recourse or nonrecourse debt (Bell 1-4). A recourse debt is a debt that the debtor is personally liable (Jones). Liable meaning that have to pay the debt even if it’s with their assets. A nonrecourse debt is one that is paid with only collateral, which means the debtor, is not personally liable for the debt (Jones). Recourse debt is the debt that we need to be concerned with when it comes to tax consequences, because it deals with the debtor paying the debt back.Foreclosures Being Treated as a Sale If the former homeowners’ debt is considered recourse and the debt is in excess of the fair market value (FMV) of the home, then the home or property is treated as a sale or disposition; by you as the former home owner and may result in your realization of a gain or a loss. Also, if the debt is nonrecourse then it is not considered ordinary income unless the former home owner retains the collateral, or the lender offers a discount for early payment of debt, or the lender agrees to a loan modification that results in a reduction in the principal balance of the debt. When comparing the outstanding balance on the mortgage and the fair market value of the house and it produces a gain then that gain is automatically becomes taxable, and if it is an nonrecourse debt then it is considered a capital gain (Bell 1-4). There is an exception to a gain though. “If a gain is realized on the sale of a home the former home owners can exclude the gain from gross income if and only if, the home was owned and used as the principal residence for periods aggregating at least two years during the five-year period ending on the date of the sale. Now of course there are going to have to be some limits, which is $250,000 for each sale (Jones). Now the question comes up, well what if a couple is married? “ If a couple is married and they are filing jointly then the exclusion is $500,000, if either spouse meets the two-out-of-five year ownership requirement and both spouses meet the two-out-of-five-year use requirement for the residence” (Jones). U.S. Policy ResponsesThe U.S. government has sponsored a handful of programs that help borrowers who homes are at risk of going up for foreclosure. They realize that foreclosed homes have become a real problem. These programs are in the form of loan modifications as an alternative method for foreclosure (Li, Wenli II,1-13). The programs can be viewed by the implementation of the Obama administration’s Making Home Affordable (MHA) program.Ways to Avoid ForeclosureShort SaleOne way to avoid foreclosure is a short sale. A short sale is when a lender allows the home owners to sale the home for less than the remaining mortgage due on the home, and lets this represent full payment of the loan (Kiani 24-29). Under this method of avoiding foreclosure the delinquent borrower will forced to move out of his/her home. “Under the Mortgage Forgiveness Debt Relief Act of 2007 (H.R. 3648) a taxpayer will not be taxed upon cancellation of debt if property sold in the short sale is the taxpayer's principal residence, or used in the IRC Sectionl21.” Deed-in-lieu of foreclosureThe Deed-in-lieu of foreclosure is a popular way to avoid foreclosure because it is a way that people can avoid being embarrassed in the public eye. The way borrowers avoid foreclosure is that they voluntarily deed collateral property in exchange for a release from all obligations under the mortgage (Li, Wenli II,1-13). Even though this approach is still a little risky it is way cheaper than your home going up for foreclose and you will still have a home to come home to.ForbearanceThere is also another type of way to avoid losing your home and it called a forbearance. A forbearance is basically an agreement or an contract between the borrower and the lender. In this case the lender will agree not to put the borrowers house up for foreclosure only for a certain amount of time only if the borrower agrees to an mortgage repayment plan that will bring the borrower current on his/her payments by the end of the period. At the end of the forbearance period, it results in full payment of the mortgage.Disadvantages of Short Sale and Deed-in lieu of foreclosureUsing short sales and the deed–in lieu of foreclosure are less popular than forbearance. There are several reasons why that is so. These two types foreclosure avoidance strategies have some major disadvantages to the borrower. As stated before their will be some tax liability that is going to be owed on the home which is not going to make the borrower too happy. “The forgiveness may create a tax liability for the former property owner because it is considered "income." Another reason why these two strategies are used less often than forbearance is because there has been some evidence that most homeowners in financial distress are not really interested in voluntarily relinquishing their home. These people are hanging on to their homes without really thinking about actually paying the loan back (Bahchieva, Wachter, and Warren 2005).BankruptcyEven though most people would not want to file for bankruptcy, if they are trying to avoid paying a tax on that portion of forgiven debt then bankruptcy might work for them, its bitter sweet. “Any debts that are released through bankruptcy are not considered taxable income. Please be aware, if you are a debtor who files bankruptcy under chapter seven or eleven of the Bankruptcy code, then a separate “estate” is created. This estate consists of property that belonged to you before the filing date. The bankruptcy estate becomes a new taxable entity, which is separate from the borrower as an individual taxpayer.” It is very important that you look at Publication 908 (Bankruptcy Tax Guide) very thoroughly because not all debts are nontaxable that go through bankruptcy, which means that it will need to go on the borrowers tax return.SolvencyIf the borrower can show that he/she is solvent before the cancellation of debt (COD), meaning that they can prove that they will be able to pay their debt back before COD then maybe no items (assets) will be taxed. Borrowers should be careful when dealing with solvency because there is no permanent document stating what items to include in the calculation.Restrictions on Cancellation of DebtWhen it comes to debt forgiveness there is a limit to the amount that can be forgiven. For an individual taxpayer cancellation of debt has a limit of two million dollars that can escape taxation. The limits are different if you are a married, the limit is one million dollars; but only for married couple who file separate returns. If the loan was taken out and the sole purpose of the loan was not to build, buy, or substantially improve then under the internal revenue code it will still count as income (from whatever source derived). Any type of income is subject to being taxed (Bell 1-4). If the borrower took out money to purchase things like cars and it had nothing to do with improving the home then it would not qualify for forgiveness of debt.ConclusionBefore you let your house go up for foreclosure it is very important that you look at all of your options. With a few minor exceptions, more than likely your home will be taxed for the forgiven portion of debt. The forgiven portion of debt is considered income and it will be taxed. In some economic situations things happen where your home could be at risk for foreclosure. There are some options that you could consider to prevent this from happening. A short sale, Deed-in-lieu, forbearance, and bankruptcy are ways that could prevent your home from going up for foreclosure, which in return could save you some tax dollars.Bibliography PageBell, Kay. "Double whammy: Foreclosure and taxes." Bankrate, Inc. (2007): 1-4. Web. 2 Oct. 2012. <, Kristopher, and Wenli Li. "Mortgage Foreclosure Prevention Efforts." Economic Review - Federal Reserve Bank of Atlanta 95.2 (2010): II,1-13. ABI/INFORM Complete. Web. 14 Nov. 2012.Jones, Sally. Principles of Taxation for Business an investment Planning. 2013. New York: McGraw Hill, 2013. Print. Kiani, Raj. "Journal of American Academy of Business, Cambridge." Journal of American Academy of Business, Cambridge. 16.1 (2010): 24-29. Web. 31 Oct. 2012. Les, Christie. "Foreclosed? Here comes the tax man." Cable News Network. A Time Warner Company. 14 April 2010: n. page. Web. 2 Oct. 2012. <;."Do I have to pay a tax on my home foreclosure?" WorldWideWeb Tax. n. page. Web. 2 Oct. 2012. <;. ................
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