For Taxation Purposes Foreclosure Is Also Treated As Sale

Foreclosure and consequent forfeiture of homes is sweeping the nation enormously, unheard of in the last 13 years. California tops the list as per reports available in the North County Times, in leading number of foreclosures and one filing for every 88 households, during the last quarter. Besides the financial tragedy of losing homes, the home owners have more complications to tackle in taxation also.

Procedurally form 1099 is to be submitted, as foreclosure is treated only as a sale for taxation purposes, to IRS intimating the gross proceeds realized out of the sale. It should get enclosed with an escrow closing statement showing the total value of the amount for which the transfer to the lender took place. Other details of unpaid taxes and accrued interest as also the principal balance of the outstanding loan at the time of the transfer are also to be furnished. All these items are treated as “credits” to form part of the sale price of the property sold.

The question arises here whether there is a taxable capital gain. In 1997, the rules pertaining to the sale of a residential property were changed and yet the impacts of these rules are not known fully by the tax payers. The present situation is a seller need not buy another home or be a senior citizen of over 55 to claim exclusion. The relevant stipulation is only that the residence is of the seller’s own and the owner must have lived there for at least two years out of the five years period ended previously. Again this two years stipulation can be circumvented if the sale is due to a job change or arising out of extraordinary circumstances. The loss of financial ability to maintain a property can be adduced as one of the extraordinary circumstances and makes way for excluding up to $500,000 for married people and $250,000 for single individuals. But unfortunately capital losses arising out of home sales are not deductible.

But this limit of $500,000 has become insufficient in the changed circumstances of home prices rising on the market, frequent refinancing needed to meet the financial commitment and hence this unchanged limit is no more an attractive and useful exclusion because of inflation. Therefore to avoid unnecessary tax burdens when you sell, the basis of the sale price should be worked out correctly by arriving at the exact cost of the home – basic purchase price plus all the expenses towards improvements made by you when the home is owned. Secondly if the home was purchased through gains of an earlier home sale – deferred by the rules existing prior to 1997 – you have more chances for reducing the capital gains further for taxation purposes.

There is another surprise tax benefit in foreclosure of your home. In the event of foreclosure process initiated by the mortgage lender, chances are that you might have defaulted in payment of interest and property taxes as well. These arrears have to be paid by the lender as part of the foreclosure process. Yet you can claim these expenses as itemized deductions, even though actually you are not paying them from your pocket in cash.

There is one more get-away route available to you, apart from foreclosure and that is by embarking on “short sale”. The details of this will be given separately in another column.

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