Analysis of a Foreclosure Sale

“Short sales” and tax consequences, part 2 of 7

In this post, we will review examples of foreclosure homes and some sample tax impacts of foreclosure.

Regardless of where you are facing a foreclosure or short sale, you must  be aware of potential tax consequences of a short sale or foreclosure.

The $250,000 capital gains exclusion plays a large role in whether you have taxable income on your personal residence post foreclosure.

Note that this analysis is limited to your personal residence in which you have lived for at least two years.

I refer to the National Consumer Law Center’s publication “Foreclosure Prevention Counseling”, 2009 edition, that is available for $60.00 at www.consumerlaw.org, in my analysis. The relevant section is Chapter 9, pages 147-152.

Discharge of Indebtedness Income is not necessarily always the same as taxable debt forgiveness income, according to the NCLC, on page 149.

Here are some “foreclosure” examples of taxable income related to the foreclosure of a principal residence. Note that this analysis would not apply if a home you rented out as a business was foreclosed. That situation is much stickier. You should see your CPA if you have a business or rental property foreclosed.

Example 1: a single person whose residence is foreclosed upon
$50,000: purchase price of home “way back when”
+$10,000: improvements to home like a new deck and changed shower to bathtub
$60,000: basis in home
The home was refinanced many times to “pull out” equity, so the debt against the home at the time of foreclosure was $325,000.
In addition, $5,000 in “cash for keys” was paid to the single person owner after foreclosure as an incentive to move out without damaging the property.
At the time of foreclosure, the house was appraised at $400,000 by the bank.
$60,000: basis (home purchase price plus $10k improvement)
$330,000: “sale” price (e.g. amount of debt $325k + $5k paid “cash for keys”
$270,000: capital gain ($330k-$60k = $270k)
$250,000: capital gain exclusion
$20,000: capital gain
$3,000: capital gain tax due ($20k x .15 = $3k tax due)

Note: in later posts in this blog, one of five exclusions to the obligation to pay $3,000 in capital gains tax may come into play
Example 2: a single person whose residence is foreclosed upon
$125,000: home acquisition price, no improvements made to increase basis
$132,000: debt owed on home at time of foreclosure, including foreclosure fees
$80,000: home fair market value at time of foreclosure as housing prices have collapsed
$45,000: capital loss-capital losses are not taxable, thus homeowner does not owe any tax due to foreclosure as a capital tax.
However, in this example, the single person foreclosed upon could potentially owe income tax (as no capital gain tax) as discharge of indebtedness income/taxable debt forgiveness income. More on this later.
In the succeeding blog posts in this seven part series, I will cover and explain how discharge of indebtedness income can result in taxable debt forgiveness income. I will also discuss the five exceptions/exclusions to tax on the income.

Remember, we are here to help you, regardless of where you are facing a foreclosure or short sale. If you need help, please contact us.

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