Capital Gains on Foreclosures
The sale of real property normally goes through an escrow process. The seller receives statements showing how much the home sold for, but with a foreclosure, there is no escrow period. The lending bank simply takes possession of the home. The basic formula for calculating capital gains is to subtract the basis or cost of the property from the sales price. The difference is how much of a profit the seller made or how much money was lost in the transaction. There’s no mutually agreed-upon sales price in a foreclosure situation and without escrow statements, but there’s still a “sales price” for tax purposes. It will be either the fair market value of the property as of the date of the foreclosure or the total loan balance plus the fair market value. That number depends on whether your mortgage was a recourse or a non-recourse loan. Both these figures are reported to you and to the IRS by the lending institution in box 2 (outstanding loan balance) or box 4 (fair market value) of Form 1099-A, “Acquisition or Abandonment of Secured Property.”
Recourse Loans
With a recourse loan, the figure used as the sales price when calculating any potential capital gain is the lesser of the following two amounts:
The outstanding loan balance immediately before the foreclosure minus any debt for which the borrower remains personally liable after the foreclosure, orThe fair market value of the property being foreclosed
You can have canceled debt income from the foreclosure with this type of loan as well, in addition to a capital gain. Example of a Recourse Loan Let’s review an example of how all of this works. Sam originally bought a house for $100,000, paying $20,000 as a downpayment and taking out a mortgage for $80,000. After two years in 2021, the bank foreclosed on the property. Suppose at the time of foreclosure, the mortgage balance due was $70,000, and the fair market value was $65,000. Additionally, Sam took a casualty loss of $15,000 on the property, making his adjusted cost-basis $85,000 ($100,000- $15,000). You’re personally responsible for the mortgage debt if you had a recourse loan. The lender can pursue you for repayment even after the property has been repossessed—it has “recourse.” If the bank forgives $1,000 of his debt, the outstanding balance at foreclosure now becomes $69,000. Sam is now personally liable for $4,000 ($69,000-$65,000). Also, he now has $1,000 in ordinary income from the cancellation of debt. To calculate his gain or loss, he now needs to pick the lesser amount between:
The outstanding loan balance immediately before the foreclosure minus any debt for which the borrower remains personally liable after the foreclosure = $69,000The fair market value of the property being foreclosed = $65,000
In this case, the FMV is the lower value. Sam will realize a gain or loss by comparing this value with his adjusted cost basis. In this example, there would be a loss of $20,000. Mortgages used to acquire homes are typically non-recourse loans, while refinanced loans and home equity loans tend to be recourse loans. This isn’t an absolute rule, however. It can also depend on the laws of the state in which you reside.
Non-Recourse Loans
A non-recourse loan is one where the borrower isn’t personally liable for repayment of the loan. The loan is considered satisfied and the lender can’t pursue the borrower for further repayment if and when it repossesses the property. The figure used as the sales price in this case is the outstanding loan balance immediately before the foreclosure. The IRS takes the position that you’re effectively selling the house back to the lender for full consideration of the outstanding debt, so there’s generally no capital gain.
You’ll Receive Tax Reporting Documents
You’ll receive one of two tax forms after foreclosure, or perhaps both:
Form 1099-A is issued by the bank after real estate has been foreclosed upon. This form reports the date of the foreclosure, the fair market value of the property, and the outstanding loan balance immediately prior to the foreclosure. You’ll need this information when you’re reporting any capital gain related to the property. Form 1099-C is issued by the bank after the bank has canceled or forgiven a debt on a recourse loan. This form will indicate how much of the debt was canceled. You might receive only a single Form 1099-C that reports both the foreclosure and the cancellation of debt, or you might receive a 1099-A and a 1099-C if your lender both forecloses on the home and cancels the unpaid debt in the same year.
Reporting a Capital Gain
You can determine the sales price after you’ve determined what type of loan you had on your property. Report the foreclosure on Schedule D of Form 1040 and Form 8949 if the foreclosed property was your primary residence. You might qualify to exclude $250,000 or even $500,000 of gain from taxation subject to certain rules:
The home was your primary residence.You owned the home for at least two of the last five years (730 days) up to the date of sale.You lived in the home for at least two of the past five years ending on the date of foreclosure.
You can still qualify for an exclusion from capital gains tax under the modified rules for calculating your gain or loss if the foreclosed property was mixed-use—it was your primary residence at one time and a secondary residence at another time. The rules are also relaxed somewhat for members of the Armed Forces.
Capital Gains Tax Rates
The rate on long-term capital gains for properties owned for one year or longer depends on your overall taxable income and filing status. Below are the capital gains tax rates for 2022 and 2023.
For tax year 2022, the tax return you’d file in 2023
Single Taxpayers
0% if taxable income is under $41,67515% if taxable income is from $41,675 to $459,75020% if taxable income is more than $459,750
Heads of Household
0% if taxable income is under $55,80015% if taxable income is from $55,800 to $488,50020% if taxable income is more than $488,500
Married Filing Jointly and Qualifying Widow(er)s
0% if taxable income is under $83,35015% if taxable income is from $83,350 to $517,20020% if taxable income is more than $517,200
For tax year 2023, the tax return you’d file in 2024
Single Taxpayers
0% if taxable income is under $44,62515% if taxable income is from $44,625 to $492,30020% if taxable income is more than $492,300
Heads of Household
0% if taxable income is under $59,75015% if taxable income is from $59,750 to $523,05020% if taxable income is more than $523,050
Married Filing Jointly and Qualifying Widow(er)s
0% if taxable income is under $89,25015% if taxable income is from $89,250 to $553,85020% if taxable income is more than $553,850
It’s a short-term capital gain if you owned your home for less than a year. You must pay capital gains tax at the same rate that’s applied to your regular income—in other words, according to your tax bracket.
When Discharged Debt Is Taxable Income
Typically, the IRS treats canceled mortgage debt as taxable income. However, under certain special circumstances that include Chapter 11 bankruptcy or insolvency of the borrower, such debt may not be included in taxable income. The Mortgage Forgiveness Debt Relief Act of 2007 (MFDRA) provided that taxpayers could exclude from their taxable incomes up to $2 million ($1 million if married filing separately) in discharged mortgage debt due to foreclosure. This tax break kept getting extended till the Consolidated Appropriations Act of 2021 lowered the exclusion limit for canceled mortgages to $750,000 ($375,000 if married filing separately). This exclusion has also been extended to 2025. That means you don’t have to concern yourself with paying income tax on debt discharged through foreclosure through the end of 2025 and if your forgiven debt doesn’t exceed $750,000.
