Tax Consequences of Foreclosure
When a foreclosure or repossession is made there are tax consequences in addition to the legal and monetary issues. When a piece of collateral is seized in place of a debt, it is deemed a sale of the property and must be reported like any other sale, as we discussed in the previous section.
For recourse loans, the amount of the realized gain is:
• the lesser of the debt immediately before the seizure reduced by any amount of the loan the debtor remains liable for after the seizure
• the FMV of the property at the time of the seizure.
For non-recourse loans, the amount realized is the amount of the outstanding loan at the time of seizure.****
**** This is the reason that, while a non-recourse loan may appear to be the best of both worlds for the debtor, it really isn’t. They may be able to get out of CODI under the non-recourse exception, but, they get hit with a much higher gain on the deemed sale portion of the transaction. Unless the property is investment use the gain will be taxed as ordinary income and may be subject to SE tax as discussed below. See Case Study #3A
The recognized gain is the amount, if any, of taxable gain. If there is a gain on the sale of a home that has been foreclosed, but that gain is able to be excluded on the taxpayers return due to the §121 capital gain exclusion, then there is a realized gain but no recognized gain.
Let’s go back to John and his car from the above examples.
In all three examples John loses his vehicle to repossession, either voluntary or involuntary. The lender will resell the vehicle and offset the remainder of the loan by the sales price less costs. The lender will attempt to collect the remaining debt and if they are unable to do so they will issue John a cancellation of debt form, Form 1099C, in the amount of the difference.
In the first example John minimizes costs by turning in the vehicle and his Form 1099C will probably show a much lower figure then in example 2 and 3. In the last two examples there are many costs associated with the legal proceedings, the time frame where back payments and interest are accruing, and the costs for the seizure of the vehicle that will be added to the final figures.
In all three cases John also has a “sale” of property to deal with for income tax purposes. With non-real personal property there will probably be a loss on the “sale” (The FMV on seizure date less the “sales” price). This loss is non-deductible. If there is a gain, the amount of the sale is reported on Schedule D for personal use property.
There is also a good possibility of John having income related to the Cancellation of Debt (CODI). This is a separate transaction and calculation from the gain or loss on the deemed sale of the property. See the worksheet below for a quick example of how the two transactions are separate, yet, related to each other. John purchased the car for $25,000. The FMV when seized was $10,000 and the outstanding loan balance was $22,000.
You can see that for the purpose of gain or loss from the deemed sale of the vehicle John has a loss of $15,000, which is a non-deductible personal use loss. But for the purpose of CODI, he has the possibility of taxable CODI of $12,000.