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Tax collector looms over foreclosures

By Cathy Moran, California Bankruptcy Lawyer

In a down market for home values, a foreclosure sale can create an entirely new creditor in the form of the IRS, collecting taxes on canceled debt.  Uncle Sam is the phantom creditor.

Homeowners facing foreclosure  may benefit from filing bankruptcy, even if they have no debt other than mortgage debt, because bankruptcy is a shield against the taxes that follow cancellation of debt.  Forgiveness of debt in bankruptcy is an exception to the tax law that treats canceled debt as income.

Here’s how the tax law works:  if the mortgage balance as of the foreclosure is $500,000 and the value of the house is only $350,000,   the foreclosure  results in  $150,000 of debt that the (former) home owner no longer owes.  A 1099 is issued and tax law treats  the $150,000  just as if the debtor had gotten a check for $150,000.  The borrower’s taxable income is increased by $150,000.

A special tax law was enacted several years ago to shield some  homeowners from COD income on foreclosure.  Where the debt was the original, purchase money loan, no phantom income was realized on foreclosure.  But if the debt was a refinance, the special sanctuary does not apply. Neither does it apply to investment property.

There is an escape from including the canceled debt in income:  insolvency, calculated according to IRS rules where retirement funds are included in the balance sheet calculation.  One of the other escape hatches is bankruptcy.  The Internal Revenue Code provides that debt forgiven in bankruptcy does not result in taxable cancellation of debt income.

In California these days, by the time a foreclosure sale is held, virtually every house is worth much less than the mortgage balance.  Some cancellation of debt is bound to occur.  Yet, homeowners are often unaware that foreclosure is a double-whammy:  lose your house and owe bunches of taxes on money you never saw.

I often advise giving up the house that is underwater and too expensive, but no one should face foreclosure without understanding the tax consequences and considering bankruptcy to at least start fresh after the foreclosure, without the cloud of fresh income taxes.

Image courtesy of moonlightbulb.

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Full post as published by Bankruptcy Law Network on January 11, 2011 (boomark / email).