Home in Foreclosure? Now for the Bad News
The West Los Angeles resident thought his life hit rock bottom when he lost his home in foreclosure. He didn’t count on the Internal Revenue Service going after him too. Some time after the foreclosure sale, the resident--who asked that his name not be used--got a tax bill that said he owed nearly $30,000 in federal taxes thanks to the “sale” of his home.
As far as tax authorities are concerned, a foreclosure is a sale. And for a growing number of financially troubled homeowners, that spells trouble.
“The thing that really catches a lot of people by surprise is that they are really down. They have lost their house and they are so distressed that they’re not thinking straight,” says Robert Solomon, tax director at Levine, Cooper, Spiegel & Co. in Los Angeles. “They don’t see their accountant until the end of the year. And then it’s a nasty surprise.”
That surprise is a huge tax bill for what many would consider to be phantom income. And that surprise is hitting more people than ever before.
About 500,000 people nationwide suffered a foreclosure last year. Another 526,143 homes were added to the “foreclosure inventory” in the first six months of 1993, said a spokesman for the Mortgage Bankers Assn. Today’s foreclosure inventory is roughly 70% greater than it was five years ago. The bulk of these homeowners will find that foreclosure results in taxable income, experts say.
Moreover, financially troubled borrowers who persuade their lenders to reduce their loan amounts in an increasingly popular process called a “cram-down” may also face tax liability, experts note. When a lender forgives part of a debt--even though this is generally done only when the home’s value has fallen dramatically and the borrower is troubled--the IRS generally considers the forgiven debt to be taxable income for the borrower.
Foreclosures often present the thornier tax problem.
The reason is fairly complex, but it has to do with special tax breaks given to homeowners and how foreclosures are treated for tax purposes, says Ernest Howard, a Playa del Rey-based accountant.
In a nutshell, homeowners who “trade up” are able to defer tax on the gain in the previous residence as long as they continue to buy a home that’s worth as much or more as the one they sold. Homeowners who don’t have financial worries often defer the taxable gains indefinitely by continuing to hold or trade residences.
Foreclosure halts the process, Solomon says.
Why? It is considered a sale by the IRS. The price is the loan amount at the time of the foreclosure. Theoretically, the taxpayer has two years to “roll” his taxable gain into another residence. But since he didn’t get any cash and the foreclosure ruined his credit rating, it’s unlikely he’ll be able to do that.
To illustrate, consider a hypothetical taxpayer, John Doe, who bought his first home 20 years ago for $100,000. Ten years later, he sold it for $150,000 and used the proceeds to buy a $200,000 home, which he later sold for $400,000. Doe’s final home was purchased for $600,000 and has a $500,000 mortgage. However, because of the numerous “rolled” gains, his tax basis in the property is just $350,000--the $600,000 purchase price minus the $250,000 in deferred gains.
Now the bank forecloses on the home to satisfy the debt. The IRS considers the foreclosure a sale at the $500,000 loan amount. So Doe has a $150,000 taxable gain. That’s $500,000 minus his tax basis of $350,000. His tax liability amounts to roughly $42,000.
It’s important to note that tax obligations usually can’t be discharged in bankruptcy. There are special rules about eliminating tax debts through the bankruptcy process, Solomon notes. It can be done, but it’s usually only possible when the IRS doesn’t make a diligent effort to collect.
Tax liability may also exist in cram-downs. If your bank agrees to settle your mortgage debt for less than the contracted amount, you could have “discharge of indebtedness” income, says IRS spokeswoman Nancy McCurley.
The good news is that you may be able to delay paying tax on this type of income if you are insolvent--your liabilities are worth more than your assets--or are involved in Chapter 11 bankruptcy, Solomon notes.
There’s nothing new about having to pay tax on forgiven debts and deferred real estate gains. However, the new tax bill makes it far more likely that you’ll get caught if you fail to report the income, Howard says.
That’s because the 1993 tax bill broadened reporting requirements and closed loopholes in the previous law for banks and savings and loans, McCurley says. All lenders that take back properties in foreclosure must now start issuing 1099-A forms, which report income from abandoned property.
What can you do if you face foreclosure--and a hefty tax obligation to boot--but don’t have the money to make good on your loan or the tax? Solomon suggests you first try to work with your lender to negotiate lower monthly payments or a longer loan term. That way you get to keep the home, and these modifications are generally not taxable.
If that fails and the lender forecloses or reduces your loan amount, leaving you with a taxable gain, consider trying to negotiate an “offer in compromise” with the IRS, he says. These are deals that allow financially troubled taxpayers to pay the government less than what’s owed because they simply don’t have the money or prospects to pay more.
