If you are a solvent taxpayer facing foreclosure on a property, you might be surprised to find yourself also owing taxes as a result of the foreclosure. In some circumstances, if the property you lose in a foreclosure is not worth the balance of the debt owed, the IRS may consider that additional forgiven debt to be income to you. This is part one in a series on reducing foreclosure tax consequences.
As real estate values increased between 2004 and 2006 some individuals took the opportunity to diversify and invest in residential real estate by purchasing rental properties. Now, some of those individuals are faced with the prospect of foreclosure as property values have declined and the economy has slowed.
When a lender takes property either through foreclosure or deed in lieu of foreclosure in satisfaction of recourse debt the transaction is treated as a sale with proceeds equal to the lesser of fair market value at the time of foreclosure or the amount of secured debt. This provision leads to debt discharge income if the amount of debt exceeds fair market value.
Individuals faced with foreclosure should consider spending $150 to have an appraisal completed at the time of foreclosure to validate the fair market value and potentially reduce debt discharge income. It should be noted that debt discharge income only occurs once the lender discharges all or part of any deficiency (excess of debt over fair market value). Please note that this discussion is limited to solvent taxpayers whereby debt does not constitute real property business debt. If you are facing foreclosure, we recommend you contact us so we can properly plan for any tax consequences that may arise as result of debt discharge income.