There seems to be some confusion about the income tax implications of foreclosure. Because a gain on the sale of a property can trigger income tax liabilities, unless the gains are invested in another piece of real estate within certain time limits, homeowners assume that any sale of their home, in foreclosure or otherwise, will cause them to owe the IRS money. However, only in certain instances will there be any liability; and there will most likely be no income tax to be paid if the house is sold at a sheriff sale for a loss.
For purposes of illustration, we will provide an example of possible numbers of a foreclosure case.
– Balance of mortgage is $400,000.
– Property sold at sheriff sale for $366,000.
– No short sale was accepted by the bank.
– Fair market value of house at time of sale was $381,000.
The first question that homeowners have is if they will have to claim the difference between what the house sold for at auction and how much the balance owed on the mortgage was at the time of sale. The answer is that no, they will not have to claim that as income. The forced sale of the property at county auction and the fact that it sold for less than what was owed at the time of sale indicates that homeowners received no proceeds from this sale. They owed $400k and the house was purchased by the winning bidder for $366k. In fact, the homeowners probably did not see a single penny of proceeds from the sale, because it is a loss. Therefore, no tax is due in this scenario.
However, if the homeowners and the lender had worked out a short sale before the foreclosure, and the bank had accepted $366k when they were owed $400k, then the foreclosure victims would have income to show. The difference between what they owed and what the bank accepts is counted by the IRS as “forgiven debt” and is taxable income. It is as if the lender gave the homeowners the $34,000, which was then used to pay down the mortgage. But this is only if there is an agreement between the homeowners and the lender to proceed with a short sale. If this does not exist, the homeowners do not receive the “forgiven debt.”
In the case of a foreclosure, where the house is ordered to be sold to satisfy the mortgage debt, the bank probably had a judgment against the homeowners for the full $400k owed on the mortgage (or more, with fees and court costs). Just because the house sold for a loss at the sheriff sale does not mean they forgave any of that debt. The house simply sold for less than what was owed, no portion of the amount owed was forgiven. Thus, with no forgiven debt, there is no taxable income.
There is just a loss on the forced sale of the property. The homeowners will not be responsible for paying the difference between the $400k that was owed and the $366k that the property was sold for at sheriff sale. And, unless the bank tries to sue the homeowners for a deficiency judgment after foreclosure (quite rare), all parties are simply done with the property. It is usually best for the homeowners to take the loss, start repairing their credit, and move on with their lives. It is a good opportunity to do so now that the foreclosure has ended.