Despite the record-high prices in real estate, some homeowners and landlords have experienced financial hardships due to the COVID-19 pandemic. Although the federal government and many states provided some relief — in the form of mortgage forbearance and moratoriums on foreclosures and evictions — many of these programs have ended or will soon end. As a result, some real estate owners are facing the prospect of foreclosure on certain properties.
To make informed decisions about how to handle these properties, it is important to understand the tax and other financial implications of foreclosure. This blog provides a brief summary.
Depending on the circumstances, foreclosure can result in recognition of gains taxed as ordinary, capital or both. You can have taxable income even if the property has declined in value since it was purchased. The tax treatment depends, in part, on whether the mortgage loan is nonrecourse or recourse. Briefly, a nonrecourse loan limits the lender’s remedies to seizing and selling the collateral that secures the loan (usually, the real estate acquired with the proceeds) even if the loan balance exceeds the collateral’s value. With a recourse loan, on the other hand, you remain liable for any shortfall and the lender is free to pursue your other assets to recover its losses.
The following is an example that illustrates the potential tax consequences of foreclosure. Ellen has a $1.1 million balance on a recourse loan secured by a building whose fair market value (FMV) has dropped to $1 million. Ellen’s adjusted tax basis in the building is $900,000. She defaults on the loan and the lender forecloses, which is treated for tax purposes as if Ellen sold the property for its FMV, resulting in a $100,000 capital gain ($1 million less her $900,000 basis). Rather than attempting to collect the remaining $100,000 balance, the lender forgives the shortfall, resulting in $100,000 of cancellation of debt (COD) income, which is taxable as ordinary income.
If, instead, the loan had been nonrecourse, there would be no COD income. Rather, the transaction would be treated as if Ellen had sold the property for the entire $1.1 million loan balance. In that case, she would have $200,000 in capital gain, treated as long-term if the property was held more than one year.
Note: COD may be fully or partially excluded from income if you are bankrupt or insolvent. However, the excluded amount is used to reduce certain tax attributes — such as net operating losses, certain tax credits, the property’s adjusted basis and passive activity loss carryovers.
Impact on Passive Losses
One potential silver lining in foreclosure is that it could free up previously suspended losses. Losses from rental real estate activities are generally categorized as passive and limited by passive activity rules. The passive loss rules provide that the disposition of an entire interest in a passive activity in a fully taxable transaction to an unrelated party will free up suspended losses and become deductible against non-passive income. The foreclosure is a fully taxable transaction for passive activity rules. Therefore, if the property was a separate activity the foreclosure would free up suspended passive losses to offset non-passive income.
Note: Losses may not be deductible if the property is part of a group that an election has been filed to treat as a single activity for tax purposes.
When assessing the financial consequences of foreclosure, do not overlook its impact on your credit report. A foreclosure — which generally stays on your report for seven years after the first missed loan payment — can lower your credit score significantly. Besides the main implication of a lower credit score, making it difficult and more expensive to obtain future financing, it is seen as a red flag for both potential employers and landlords.
For more information about the tax and financial implications of foreclosure — as well as strategies for avoiding it — please contact contact Ryan Kertes at [email protected] or 312.670.7444. Visit ORBA.com to learn more about our Real Estate Group.