What are the tax consequences of foreclosure?

You could incur significant tax liability when you experience a foreclosure. Even if you have an attorney handle your foreclosure you should always consult with a tax attorney as well, as you may be subject to a capital gains tax.

The capital gains is calculated as the difference between the sales price and the basis in the house.

Basis = purchase price + any qualifying repairs.

Sales price = the lower of the debt forgiven plus any cash and the fair market value of the home.

Capital gains = sales price minus the basis.

In other words, let's say you bought the house for $100,000 and at foreclosure it is worth $325,000 (fair market value). But you owe $400,000 mortgage. If the lender forgives this loan, or takes a deed in lieu, your basis would be (assuming no qualifying repaires) $325,000-$100,000. In this scenario, you would use the fair market value as the sales price because it is lower than the debt forgiven. Remember that the sales price is the lower of the debt forgiven plus any cash and the fair market value. So your capital gains here is $225,000 (sales price minus basis.)

Let's assume the house was worth $400,000 (fair market value) but you owe $325,000 in mortgage. The basis would still be $225,000.00 because you are always going to choose the lower of the debt forgiven and the fair market value as your selling price. In this scenario your capital gains is selling price minus basis: $325,000-$225,000 which is $100,000. Your capital gains is $100,000.00

Let's assume all of the above but now you had made qualifying repairs of $100,000. Your basis would be purchase price plus qualifying repairs. That would be $100,000 plus $100,000. Your basis is $200,000. If your basis is $200,000, what is your capital gains? Remember that the capital gains is the selling price minus the basis....

Now let's say you are trying to figure out your capital gains in these two scenarios. The fair market value is $325,000. The basis is $100,000. So the capital gains is $225,000.

In the second scenario, the basis is $200,000 and the fair market value is $325,000. So the capital gains is $125,000. If the house is worth $325,000 but you owe $400,000 you would use $325,000 as the selling price (you are always going to use the lower of the two numbers.) So your capital gains would be $325,000 selling price minus $200,000 basis which is $125,000 in capital gains.

What would you actually pay to the IRS? In this example, you would pay nothing. Why? Because luckily each homeowner can exclude $250,000 once every five years if they are in residence at the time of the foreclosure. If married, the exclusion is $500,000 which is essentially $250,000 for each tax payer.

Had the example yielded a capital gain of over $250,000, then the homeowner, if single, would owe capital gains on the difference, after excluding the first $250,000.