Losing a home to foreclosure can be catastrophic. The mortgage lender claims the property. The homeowner is forced to move, and his or her credit and future ability to buy a home are affected.
In some cases, foreclosure isn't the end of a homeowner's problems. Sometimes a foreclosure can also trigger capital gains taxes the homeowner has to pay.
Who pays capital gains tax?
Capital gains is profit on the sale of an asset that increased in price after purchase. For tax purposes, foreclosure is considered a sale of the property, because the homeowner turned the property over to the bank.
The Mortgage Debt Relief Act of 2007 amended the tax code, making debt forgiven by the lender not subject to capital gains tax. However, certain loans, such as home equity loans, refinance loans, and second residence loans, can still be subject to capital gains tax in the event of foreclosure.
Nonrecourse loans vs. recourse loans
Not everyone who loses a property to foreclosure can avoid capital gains taxes. The tax status is partly determined by whether the mortgage loan was a nonrecourse loan or a recourse loan.
A nonrecourse loan is a loan in which the borrower is not personally responsible for debt repayment in case of foreclosure. The lender takes the property that secured the loan in lieu of repayment. In most cases, a first mortgage on your primary residence is a nonrecourse loan.
A recourse loan is a loan in which the borrower is personally responsible for the debt. Even after the property has been repossessed, the lender can seek repayment of the loan. Refinancing loans and home equity loans are usually recourse loans. These loans are usually taxable when the home is lost to foreclosure.
As long as someone has lived in a home for at least two years, the first $250,000 of profit that the person earns on the sale of the home is not taxable. For a couple, that amount doubles to $500,000. This exclusion also applies to homeowners who lose their homes to foreclosure. Even if someone had a recourse loan as the mortgage on his or her primary residence, he or she can invoke this law to avoid paying capital gains taxes.
A recourse loan holder has a few options for avoiding capital gains taxes in case of foreclosure. First, up to $2 million in canceled debts can be excluded, as long as the money borrowed was used to buy or build a home. However, this exclusion does not apply to second homes or investment properties.
This exclusion also does not apply to cash-out refinancing debt.
Next, a home equity loan can avoid taxation by using the insolvency exclusion for canceled debts. This tax law applies to those whose debt liabilities exceed the fair market value of their assets. That's often the case in foreclosure, where the amount owed on the mortgage is greater than the amount for which the house can be sold. Claiming insolvency can often help avoid taxation.
Find expert help
While several loopholes can help a homeowner avoid capital gains tax in case of foreclosure, the laws have to be applied properly to ensure effectiveness. Always consult an accountant when facing foreclosure, so you can benefit from tax laws that are designed to help struggling homeowners.
Updated from an earlier version by Gilan Gertz