Foreclosure Can Often Result in Complicated Tax Burden
Despite the long slide in local housing prices, one boom market in local real estate has been foreclosures. Last year a record 3,650 single-family houses and condominiums in the Valley were foreclosed, according to TRW-REDI Property Data in Riverside.
And that was before last month’s Northridge earthquake. Given the hefty 10% deductibles most homeowners face on their earthquake-insurance policies, and because many people now have mortgages bigger than the value of their home, many homeowners figure to walk away from their mortgages and let the property go into foreclosure.
Even for those whose homes escaped damage from the earthquake, the job market remains tough, and layoffs keep mounting, so many people will continue to have problems making their mortgage payment.
No matter what the reason, if a home is foreclosed on, that property owner faces plenty of complicated tax burdens.
If your home suffered significant earthquake damage, you may be eligible for special tax breaks--although it depends greatly on the tax basis of your house and the size of your adjusted gross income. It will also probably take an accountant to sort out the couple dozen possible tax formulas on earthquake deductions. For do-it-yourself tax filers, start with additional information on earthquake disaster losses: Call the Internal Revenue Service and ask for Publications 547 and 584 on Nonbusiness Disasters and Publication 334, a Small Business Tax Guide.
As for homeowners who had foreclosure tax headaches even before the earthquake:
Consider Ed and Ann Smith, who purchased their first home in Van Nuys in 1988 for $190,000. They borrowed $152,000 to help pay for the house that today is worth only $130,000. Ed lost his job and the couple was four months delinquent on their mortgage in the fall of 1993.
What would you do?
The Smiths--whose names have been changed here to protect their privacy--were very concerned about their credit rating. Facing foreclosure, they placed their home on the market and debated what to do when they found a buyer willing to pay the home’s current $130,000 market value.
The Smiths consulted an accountant about the tax implications of each alternative they were exploring. What the Smiths--and many other financially strapped homeowners--discovered was that the IRS considers debt forgiveness as taxable ordinary income. The IRS may also have a stake in any deferred capital gains associated with a foreclosure.
The resulting tax bill for a troubled homeowner can be staggering. The Smiths, for example, ended up with an $8,000 tax bill even though they lost money on their home.
The Smiths had three options, said their accountant Bob Solomon, a partner at West Los Angeles-based Levine, Cooper, Spiegel & Co. The first was to sell their Van Nuys home for $130,000 and turn that money over to their mortgage lender, along with the $20,000 still owed on their loan.
This would have left the couple with a $60,000 loss, $20,000 out of their pockets and no tax bill. It should be noted that if the Smiths had a deferred gain of, say, $100,000 on a previous residence, the tax basis of their $190,000 home would have been $90,000.
In such a case, the IRS and California’s Franchise Tax Board would demand their share of a $40,000 “gain” realized by the Smiths--unless the couple had the wherewithal to roll over into another home within two years. This, of course, is easier said than done for a family already facing financial ruin.
The second option, Solomon recalled, was allowing the home to be foreclosed. The IRS considers a foreclosure to be a sale and the IRS deems the sales price equal to the loan balance. Here, the loss to the Smiths would be $40,000 and they would suffer the negative repercussions of a foreclosure. If this had been their second home--as in the first option--the IRS and Franchise Tax board would want their share of the Smith’s $60,000 gain--roughly $24,000.
A third option is the one that the Smiths chose. They sold the home for $130,000 and realized a loss of $60,000. Their lender forgave them the other $20,000 still owed on the loan, but the Smiths had to pay $8,000 in taxes for the $20,000 in debt forgiveness. If this had been their second home and they had rolled over a $100,000 gain from before, they would have had a $40,000 “gain” and an additional capital gains tax obligation of about $16,000.
If you’re not confused by the numbers, you may be shocked by the size of the potential tax bills. The tax issue is further complicated because capital gains are taxed by the feds at about 28%, while the “ordinary income” of debt forgiveness is taxed on a sliding scale of 15% to 39%, depending on your tax bracket.
There’s still more complexity to a borrower’s tax obligation when there’s a foreclosure or debt forgiveness. First, when a debtor is insolvent, the IRS won’t hold the debtor responsible for the debt cancellation to the extent of the debtors’ insolvency. Second, if there’s a foreclosure, a debtor who is personally liable for a debt may also have to pay tax for debt forgiveness, noted Steven M. Friedman, West region director of real estate advisory services at accounting firm Ernst & Young in Los Angeles.
Another twist to these tax rules is that cancellation of a debt obligation by a lender will no longer necessarily result in income for tax purposes. Many borrowers have complained that they’ve been hit not only with a reduction in their property values but also with a tax bill when a lender forgave some of their debt. Owners of commercial property will now be able to defer any “income” that results from debt forgiveness--as long as the taxpayer owns another commercial property. Residential property owners should know, however, that this change only applies to commercial real estate. Starting last month lenders must fill out IRS form 1099 for any residential debt they forgive.
“The tax implications of debt forgiveness and foreclosure are extremely complicated,” said Chris Carlson, a tax partner at accounting firm Deloitte & Touche, which has offices in Woodland Hills.
He advises troubled homeowners to sit down with an accountant and figure the tax bill on each of the options that are available. Also, if there is any deferred capital gains tax from previous residences, he said, all or part of that gain can continue to be deferred if the taxpayer buys another residence within two years or if the taxpayer is 55 or older.
