Do you Know the Consequences of Foreclosure?
If you have ever been threatened by foreclosure, chances are high that you were unable to pay off your mortgage to the lender for a considerable length of time. However, if the mortgage lender decided to take your home away due to term violations, namely payment, it may have lead you to think that the situation was futile. But there are actually many ways to avoid the terrible consequences of foreclosure. People threatened by foreclosure have the option to file for bankruptcy, refinance, short sale, negotiate temporary arrangements with their lender or utilize the deed in lieu procedure.
Although it is beneficial to learn about the ways to avoid foreclosure, you must be prepared for the worst as well. There are several tax, credit and legal consequences of foreclosure.
One of the major consequences of foreclosure is damage to your overall credit. If someone fails to pay off his or her mortgage over the stated 30-day period, it will remain as a black mark on his or her credit report. Failing to pay off bad credit scores automatically results in denial of any future applications for loans, mortgages and credit cards. It could take a person up to three years to stabilize their credit score. Damage to your credit score is caused by either the consequences of foreclosure or real estate being lost from a deed in lieu.
Although there are many consequences, there are also several positive things that can result from foreclosure. One of these positive things are if you bought your real estate with a mortgage more than 2 years ago then, according to a 2007 law called the Mortgage Forgiveness Debt Relief Act, it can be sold either by short sale or auction for less than your actual debt. Furthermore, you are not obligated to pay taxes on the difference in rates and the lender will never ask it of you, if you bought your real estate more than 2 years ago. However, if you bought your real estate with a mortgage less than 2 years ago, or have applied tax-deferred capital gains, the national tax office has the right to make you pay further taxes on your property.
Two of the many key terms that describe the consequences or causes of foreclosure are short sales and missed mortgage payments. Both of these key terms are widely used and have a strong connection with the foreclosure process.
Missed mortgage payments are when borrowers fail to pay their mortgages over the deadline acceptable by their lenders, which is normally within 30 days.
Short sales occur when someone sells their real estate under mortgage and foreclose their property for a lower price than what the actual debt is. Due to the aforementioned Act of 2007, lenders nowadays cannot sue short sellers for the payment difference.
Seek advice from a legal expert!
You probably know that foreclosures are increasing dramatically on all types of properties, from vacation homes to commercial sites. Nonetheless, the boom in foreclosures probably is being felt mostly by homeowners.
The prospect of your losing your home can be stressful enough. You might be trying to figure out a way to catch up on the mortgage to avoid foreclosure, or maybe trying to find a new place to live. While you’re concentrating on important things like that, it’s easy to overlook the tax consequences for home foreclosures, which may come as an unpleasant surprise.
After the foreclosure is done, it’s possible to get a tax bill from the Internal Revenue Service (IRS). Whether you’ll get such a bill depends on a number of things, like:
Was your mortgage a recourse or non-recourse loan
Whether the foreclosure is treated as a sale of the property or the cancellation of a debt
Whether the Mortgage Forgiveness Debt Relief Act of 2007 (MFDRA) applies to you
Recourse or Non-Recourse
If your mortgage is a recourse loan, you’re personally responsible for repaying the bank or mortgage company. If you don’t repay the loan, or “default,” the bank can sue you for the remaining amount due on your loan if the proceeds from a foreclosure sale doesn’t cover the amount you owe.
On the other hand, if your mortgage is non-recourse, your lender can’t make you pay the loan. The only thing it can do is foreclose and sell your house for payment on the debt.
Sale
Regardless of whether your mortgage is recourse or non-recourse, the foreclosure is a taxable sale for you. This is true even if you give the lender a deed to your home in satisfaction of the debt, which is called a deed or transfer “in lieu of foreclosure.” Because the foreclosure is treated as a sale, you have to report any gain from the sale as income, and you’ll be taxed on that gain.
You don’t get a deduction for any loss that you might have as a result from the foreclosure.
Figuring a Gain
As with any other sale, you figure your gain from the foreclosure by taking the difference between the amount realized from the sale and the adjusted tax basis of the home. Usually, your adjusted tax basis equals the price you paid for the home plus the costs of major improvements. The amount realized generally equals the gross proceeds minus expenses. In a foreclosure the amount realized depends a lot on whether your loan is recourse or non-recourse:
For recourse loans, if your home is sold at a foreclosure sale, the amount realized is its fair market value, which is generally the sales price, minus expenses of the sale, such as court costs, legal fees and real estate commissions
For non-recourse loans, your amount realized equals the amount you owed on the mortgage plus any interest that comes due up to the time of the foreclosure
Cancellation of Debt
Generally, if you borrow money from banks or credit card companies, and the lender cancels or forgives that debt, the amount of debt that was cancelled is income for federal tax purposes. The cancelled debt is “money in your pocket” because it was loaned to you and you don’t have to repay it.
Until recently, the same logic applied to most recourse mortgages. After surviving the stress of foreclosure, many people were surprised by a tax bill from the IRS. Say at the time of foreclosure you still owe $200,000 on your mortgage, but according to the bank’s appraisal, the fair market value of the home is only $190,000. If you transfer the house to your bank in lieu of foreclosure and the bank doesn’t make you pay the $10,000 difference, or “deficiency,” then you have a $10,000 taxable gain.
There are some exceptions. For instance, debts that have been discharged through bankruptcy aren’t considered taxable income. Similarly, if you’re insolvent – your total debts are more than the fair market value of your total assets – when the debt is cancelled, some or all of the cancelled debt usually isn’t taxable.
In the case of non-recourse mortgages, there is no cancelled or forgiven debt. With these mortgages, the amount realized on foreclosure (or transfer in lieu of foreclosure) is never less than the outstanding debt. In other words, the price the property sells for at foreclosure is treated as the balance owed on the loan, no matter what the sale price may be.
The Mortgage Forgiveness Debt Relief Act (MFDRA)
Late in 2007, spurred by soaring home foreclosures, the MFDRA became law. Generally, it lets you exclude from your taxable income most if not all of any cancelled or forgiven debt that might come about because of a foreclosure. There are limits, however:
The cancelled debt has to be on your principal residence. The debt can be from a loan that you took out to buy, build, or substantially improve your home, or for refinancing the mortgage on your home. Because it applies only to your principal residence, commercial and vacation properties usually don’t qualify
Only debt that is forgiven in 2007, 2008, or 2009 qualifies
If you file a joint tax return with your spouse, you can exclude up to $2 million of forgiven debt from your income. If you’re married and file separately, you can exclude up to $1 million
You have to report the amount of forgiven debt on a special IRS form and attach it to your tax return
If your forgiven debt doesn’t qualify under the MFDRA, don’t forget about the insolvency and bankruptcy exceptions noted above.
Questions for Your Attorney
If given a choice, should I choose a recourse or non-recourse mortgage?
If I bid on my house at the foreclosure sale and win, can I still take advantage of the Mortgage Forgiveness Debt Relief Act?
I’m trying my best to pay my mortgage on time, but it’s getting harder each month. Realistically, I don’t see how I can avoid foreclosure in late 2009 or early 2010. Given that the Mortgage Forgiveness Debt Relief Act won’t apply after 2009, do you think I should stop paying my mortgage now and force the bank to foreclose?
Carmen Arruda
How long can you ocupy the home. Before they evict you?
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