The Dangers of Foreclosure: “Out of the Frying Pan and Into The Fire”

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 a few quick 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.

Scenario 3 – An investor buys a rental house 10 years ago for $160,000.  Over time the house appreciates in value and 3 years ago the investor does a “cash out refinance”.  Based on the new higher value the investor gets a new loan for $200,000 and uses the additional proceeds to send a child to college.  Now decreasing rents or other financial problems have made it uncomfortable for the investor to keep the house with a negative cash flow.  So the investor stops making payments and the lender forecloses and the property is “sold” on the courthouse steps for $200,000.  The investor has no cancellation of debt but there is a capital gain.  The investor bought the house for $160,000 and sold it for $200,000 so there is a gain of $40,000.  The Federal capital gains tax rate for 2010 is 15% (it is expected to go up in 2011 plus we have the new 2.9% Medicare tax on capital gains from our most recent health care legislation).  So the Federal capital gains tax will be $6,000 in 2010.  The investor also depreciated the property over 10 years with total deductions of $49,000.  So the tax on recapturing those depreciation deductions will be approximately $12,250 for a total tax obligation of $18,250.

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.

Several caveats:  Some investors may choose to take advantage of their rights under the American Recovery and Reinvestment Act of 2009 to delay the recognition of some of these taxes until 2014.  The tax obligation is still there but payment is postponed.  Other clients that started out as frustrated sellers may be able to classify the house as their personal residence (they lived there at least 2 of the past 5 years) and take advantage of some protections under the Mortgage Debt Relief Act of 2007.  The investor may have a lot of accumulated losses which might offset some of these capital gains.  Each person’s situation will be unique.  It may be best to consult with an accounting professional.

Mike Nelson, GRI, RMP, MPM is the managing broker of Excalibur Home Management, LLC  which currently represent over 1200 rental houses in the Metro Atlanta area.
Blog posted by John Durham, Marketing & Communications Director with Excalibur Home Management, LLC.

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