Q: How does it work if the bank forecloses on my house? Is there a tax consequence? How does the capital gain exclusion apply?
A: There are two separate issues here. Recourse debt (which mortgage debt almost certainly is) that is forgiven is considered "cancellation of debt" income. If there is a capital gain, it may be able to be excluded under the usual rules...
Cancellation of Debt Income
Suppose you have a mortgage with $200,000. The fair market value of your home has fallen to $170,000. You fail to pay your mortgage, and the bank forcloses on the home, selling it for the $170,000 fair market value. The bank determines you cannot pay back the remaining $30,000 that you owe. It forgives the debt to you.
You then have income of $30,000 (which you must pay taxes on). There are only a few exceptions to this rule:
- The debt forgiveness happens under the context of a Chapter 11 bankruptcy supervised by a court
- The taxpayer is insolvent (meaning his total debts exceed his total liabilities)
- The property is qualifying farm income
- The property is real property owned by a non-C corporation business
This should be coming up more in the tax world as the housing bubble and credit crunch work their way into the real world.
How is this fair? Simple. The bad debt is forgiven you and deducted off the mortgage holder's books. This income is then realized by you, and you must pay income tax on it (with a few exceptions). The unlucky taxpayer will receive a Form 1099-C, Cancellation of Debt, from the lender.
President Bush (and others in Congress) have called for creating an additional exception for cases in which the forgiven debt is tied to your primary residence.
Exclusion of Capital Gain
Surely, then, someone who faces this forgiveness of debt income would not also face a capital gain. If you think that, you'd be wrong.
Let's stick with our example from above. Our homeowner had $200,000 of mortgage debt, but a lot of that was cashing out his home equity. He actually bought his home for $150,000. When the home was disposed of for $170,000, he had a $20,000 capital gain.
Our unlucky homeowner in this case is facing a $20,000 capital gain, $30,000 forgiveness of debt income, and no place to live.
Fortunately for him, Section 121 of the code allows him to exclude up to $250,000 of gain ($500,000 if married) every 2 years on the sale of his main home, provided he lived in and owned the home for any 24 of the 60 months prior to sale (pro-ration exceptions apply). Chances are, if he has a capital gain he can exclude it.