A foreclosure or repossession may be the result of the non-payment of a loan secured by the property. When the lender forecloses on the property, the transaction is treated as a sale or exchange for income tax purposes. In the case when there is discharge of the recourse debt (debt you are personally liable for), there may be gain or loss on the disposition and potential CODI. In addition, you must determine the character, excludability and deductibility of any gain or loss.
Fair market value or FMV has attracted a lot of attention lately. IRS normally assumes that the value entered on Form 1099 is correct but if you disagree with the lender’s value, you immediately contact the lender. If you are sure the value is incorrect, you can dispute the amount by providing information from reliable sources to support your argument.
Now, if the outstanding loan balance is greater than the fair market value of the property and the loan balance or debt is cancelled, you may realize ordinary taxable income unless an exception applies.
To determine this, the amount realized from the transaction will be the smaller of the fair market value (FMV) of the residence or the outstanding debt immediately prior to the disposition. Thus, if the FMV is less than the total outstanding debt immediately prior to the disposition and you remain personally liable after the transfer, the difference becomes ordinary taxable income from the cancelled debt. However, if you are not personally liable for the debt (non-recourse loan), you do not have ordinary income from the cancellation.
Your adjusted basis in the property is the same as it would be in the case of a sale or exchange:
your original basis cost + any additions or improvements – any depreciation claimed, casualty losses or other adjustments.
The difference between the amount realized and your adjusted basis is your gain or loss on the foreclosure or repossession. If there is a gain, it could be personal capital gain, reported on Schedule D, or a capital gain on business property, reported on Form 4797.
For assistance with this tax situation, please contact our office for qualified and experienced help!