Foreclosure – Out of the Frying Pan …

Mike Nelson
Mike Nelson

During the past two years several of our clients have lost property to foreclosure.  Often they don’t notify us or consult with us about their circumstances.  They just decide one day that they are no longer willing to carry a property with a negative cash flow so they stop making payments.  But there may be significant tax consequences for the client that loses the property thru foreclosure or a short sale.  The investor may still owe Capital Gains Tax, tax on Cancellation of Debt (COD), and/or tax on the recapture of depreciation deductions taken on the property.

 What is Cancellation of Debt? (From IRS.gov)

If you borrow money from a commercial lender and the lender later cancels or forgives the debt, you may have to include the cancelled amount in income for tax purposes, depending on the circumstances. When you borrowed the money you were not required to include the loan proceeds in income because you had an obligation to repay the lender. When that obligation is subsequently forgiven, the amount you received as loan proceeds is reportable as income because you no longer have an obligation to repay the lender. The lender is usually required to report the amount of the canceled debt to you and the IRS on a Form 1099-C, Cancellation of Debt.

Here’s a very simplified example. You borrow $10,000 and default on the loan after paying back $2,000. If the lender is unable to collect the remaining debt from you, there is a cancellation of debt of $8,000, which generally is taxable income to you.

Here are two examples to illustrate the problem:

Scenario 1 – An investor buys a rental house in 2005 for $160,000 and gets a $152,000 mortgage (we saw several deals like this in our market back then).  Now the investor is experiencing a negative cash flow of about -$300 per month.  So the investor stops making payments on the property.  The lender forecloses and the property is bid in at the courthouse steps by the lender for the mortgage balance of $150,000.  Since it “sold” for the amount of the mortgage, there is no cancellation of debt.  The investor depreciated the property over 5 years for a total of $27,000.  Now the investor will owe the tax (25% Federal) on recapturing those depreciation deductions which would be approximately $6,750.

Scenario 2 – An investor buys a rental house in 2005 for $160,000 and gets a $152,000 mortgage.  Now the investor is experiencing a negative cash flow of about -$300 per month.  So the investor stops making payments on the property.  The lender forecloses but since the property is now worth much less today it is sold on the courthouse steps for $130,000.  The investor’s outstanding loan balance at the time of sale is %150,000.  So the investor has a $20,000 cancellation of debt which could be taxed as ordinary income.  The investor depreciated the property over 5 years for a total of $27,000.  Now the investor will owe the tax (25% Federal) on recapturing those depreciation deductions.  The investor’s total tax obligation may be as much as $11,700 for just Federal tax.

Then there are other ramifications due to the negative impact the foreclosure has on the investor’s credit.  This could lead to higher interest rates from lenders or being denied some types of financing.  All to get away from a $300 per month negative cash flow.  Based on the above examples, it may well be cheaper to “tough it out” for the next 2 – 3 years then sell the property as the market gets a little stronger.  Do the math first – not once it is too late.

Mike Nelson, GRI, RMP, MPM is the managing broker of Excalibur Home Management, LLC  which currently represent over 1100 rental houses in the Metro Atlanta area.

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