Tax Consequences of Foreclosure

June 23, 2011

Over the last few years foreclosures have been a top news story. Surprisingly, what has received little coverage is the potential tax implication of foreclosure.

Many people may think that a bank foreclosure ends the financial nightmare and are surprised when they receive a letter from the IRS about taxes due in connection with the residence they no longer own.  If you lose your home through a foreclosure, there are two possible tax consequences you must consider: taxable cancellation of debt income, or a reportable gain from the disposition of the home.

The Mortgage Forgiveness Debt Relief Act and Debt Cancellation

For most individuals, a foreclosure will result in a Cancellation of Debt (COD) by the lender.  Normally, debt that is forgiven or cancelled by a lender must be included as income on tax returns and is taxable.  The Mortgage Debt Relief Act of 2007 was enacted to allow taxpayers to exclude up to $2 million (if married filing jointly) of income from the cancellation of debt on their principal residence in 2007 through 2012. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief. All forgiven debt must be reported on IRS Form 982 and attached to your tax return.  Second homes and investment properties do not qualify for the Mortgage Debt Relief Act and any cancellation of debt may be taxable.

Gain from Foreclosure

Not every foreclosure is a loss for the homeowner; under certain circumstances a small number of individuals may realize a gain from foreclosure.  Because a foreclosure is treated as a sale for tax purposes, there may be taxable gain to report as a result of the foreclosure. If the property was used as the principal residence for at least two years during the five-year period ending on the date of foreclosure, up to $250,000 (up to $500,000 for married couples filing jointly) can be excluded from income. If the taxpayer does not qualify for this exclusion, or if the gain is more than the exclusion amount, then the gain should be reported on Schedule D as a capital gain.

Gain from foreclosure is calculated by comparing the fair market value of the property to the adjusted basis (purchase price plus cost of any major improvements) in the property.   If the fair market value or debt amount

is greater than the basis, then there is a gain on the foreclosure.  That gain is reportable unless the taxpayer qualifies for the exclusion.

For more examples and details on the tax implications of foreclosure, you can consult IRS Publication 4681 (Canceled Debts, Foreclosures, Repossessions, and Abandonments).  At Wallace & Associates, it’s our mission to provide all of your taxation and accounting needs, and have the latest information to keep you compliant and timely with filings.


In case you need advice on how a foreclosure affects your taxes or accounting, contact Wallace & Associates Certified Personal Accountants serving the Los Angeles area.
Check out our blog post about mortgage modification tax consequences.