First, if you sell a primary residence at a loss (for less than what you originally paid for the property plus the cost of any improvements), you will not receive a tax deduction. Now if you engage in a short sale or let a personal residence go into foreclosure, then you may owe capital gains tax on the amount of any debt forgiven by your lender(s) depending on the type of loan you have (recourse loan or non-recourse loan).
Non-Recourse Loan.
In California, if you take out a loan to buy a house or a building with up to four units, and you live in the house or one of the four units, the loan is a non-recourse loan. With a non-recourse loan, if the lender forecloses, accepts a deed in lieu of foreclosure, agrees to the terms of a short sale, or in any fashion takes control over your personal residence, the lender must accept the personal residence as complete satisfaction of your debt; the lender cannot go after you personally for any short-fall.
Recourse Loan.
If a homeowner with a non-recourse loan acquires a home equity line of credit, or refinances the original non-recourse loan, the home loan will become a recourse loan. With a recourse loan, the borrower is personally liable for repayment.
Taxes on the Sale Proceeds or Loss.
When a lender takes over a property, it is treated as a sale. The "Sale Price" is the amount of the outstanding debt. The capital gain or loss is the difference between this debt and your adjusted cost basis (amount originally paid to purchase the home plus the cost of any capital improvements). If the amount of your debt exceeds your cost basis, you will have a capital gain, even if no money reaches your pocket or bank account. If this alleged gain is less than $250,000 ($500,000 if you are married), the alleged gain is exempt and you won't owe any capital gains tax.
In addition to having a capital gain, you may also owe income tax on “Cancellation of Debt Income” (the amount of debt owed to the lender minus the fair market value of the property). Cancellation of debt is taxed as ordinary income. If the amount of debt cancelled exceeds $600, the lender(s) is supposed to send you IRS Form 1099-C showing the amount you must report on your tax return.
Now, if the sale price plus what you owe the lender is less than what you originally paid for the personal residence, and you actually remit payment of any outstanding balance to your lender, you will have a capital loss. Unfortunately you will not be able to deduct the capital loss on your taxes.
Real Life Examples.
Now let’s use three real life examples to further explain the above tax consequences.
Example No. 1:
Suppose you buy a house for $700,000 and make no improvements. You put down $70,000 and borrowed $630,000 with an adjustable-rate, interest-only mortgage. Now your rate re-adjusts, the value of your home has declined, you can’t refinance or make your payments, and the lender forecloses on your home, now worth only $550,000.
Because you didn’t refinance or take out a home equity line of credit, your mortgage remained a non-recourse loan. You will have a capital loss of $150,000 ($550,000 fair market value minus $700,000 cost basis). You won't owe any tax, but you won't get a $150,000 tax deduction if this is your primary residence.
Example No. 2:
Suppose you buy a house for $500,000. You put down $50,000 and borrowed $450,000. Three months later, you refinance and take out an additional $50,000 o make improvements. You now owe $500,000 on a new adjustable rate, interest only mortgage. Now your rate re-adjusts, the value of your home has declined, you can’t refinance or make your payments, and the lender forecloses on your home, now worth only $400,000. Because you refinanced, your original non-recourse mortgage became a recourse loan. Consequently, you will have a capital loss of $100,000 ($400,000 fair market value minus $500,000 cost basis). You won't owe any tax, but you won't get a $100,000 tax deduction if this is your primary residence. Now, in addition to losing the deduction for the $100,000 capital loss, you also might owe income tax on the cancellation of debt ($500,000 owed minus $400,000 fair market value), leaving a balance owed to the lender of $100,000. It should be noted that, at least temporarily, new tax legislation has been passed to eliminate cancellation of debt tax under certain limited circumstances.
Example No. 3:
Assume you paid $400,000 for your home. Assume that years later you refinanced the home to pull money out and you now owe $700,000 on your home. Assume further that property values in your area declined sharply and you can only sell the home for a net sale price of $500,000. For tax purposes, you will have a $100,000 gain if you sell, because the sale price ($500,000) exceeds your original cost basis ($400,000) by $100,000. The IRS does not care that you are upside down on the property and are losing $200,000 ($700,000 of debt vs. the $500,000 sale price); In their eyes, you have made $100,000 on the property. The good news is that you will probably qualify to exclude the capital gain for federal income tax purposes ($250,000 if simgle; $500,00 if married).
IRS Circular 230 Disclosure: As required by U.S. Treasury Regulations, you are hereby advised that any written tax advice contained on this web site is not written or intended to be used (and cannot be used) by any taxpayer for the purpose of avoiding penalties that may be imposed on a taxpayer under the U.S. Internal Revenue Service.
