Mills on Foreclosure Tax Issues for Homeowners

Mills on Foreclosure Tax Issues for Homeowners

In this Analysis, Patricia Hughes Mills discusses the tax consequences when homeowners either lose their homes due to foreclosure or are able to avoid foreclosure by loan modification. Professor Mills includes a checklist of related questions for attorneys to ask distressed homeowner clients. She writes:

     The tax consequences of foreclosures and debt modifications will depend on certain factors, such as whether the loan is recourse or nonrecourse, whether the debt involved is acquisition indebtedness or a home equity loan, and whether or not the property is the taxpayer's principal residence. This article looks at the tax consequences of foreclosure and debt relief from the residential borrower's perspective. Different consequences, not addressed here, will apply to the lender.

     In most situations where foreclosure occurs or is threatened, the value of the property has fallen below the amount of the debt. Whether the property owner transfers the property to the lender in lieu of a foreclosure, or the property is sold in foreclosure, the property owner has experienced a transfer of his or her property that will carry tax consequences. In addition, if the borrower is relieved of the obligation to pay the amount of debt that exceeds the property's value, then the borrower may have debt relief. Debt relief is generally taxable income unless certain exceptions apply. Furthermore, the consequences may differ between recourse and nonrecourse loans. It is this potential combination of factors which adds to the complexity in this area. Let's look at several scenarios:

When the principal residence is

·sold in a foreclosure to lender or third party or

·transferred to lender in lieu of foreclosure and

·loan is nonrecourse debt (i.e., borrower is not obligated to pay excess of loan balance over property value),

the debtor is treated the same as if he or she had sold the property to a third party. Thus, gain is measured by the difference between the sales price of the property and the debtor's basis in the property. Here, the sales price of the property is considered to be the amount of the nonrecourse debt. The property owner is essentially treated as having a taxable exchange of the property for the debt. The property owner thus has gain or loss equal to the difference between the outstanding loan and his or her basis in the property.

(footnotes omitted)

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