Foreclosure and Tax: What are the pitfalls?

Seattle Skyline - 400 x 266A question recently arose when dealing with a client facing the loss of a distressed property: “how am I taxed if I should allow the property to go through the foreclosure process? Am I taxed on the balance of the loan that is not collected as a result of the foreclosure.” The short answer is that yes, you’re probably exposed to some tax liability. (This also goes for short sales and deeds-in-lieu of foreclosure when the bank elects to waive whatever deficiency it could have obtained.)

Typically, when debt is cancelled by a creditor, it results in ordinary income to the debtor. For instance, if you owe someone $50,000 and they simply forgive that debt, then you’ll be responsible for income of $50,000 for the year that the forgiveness took place. There are other tax considerations that offset this impact potentially, but the general rule applies.

However, there are nuances in the tax code when it comes to foreclosure. According to the IRS, if your loan is a non-recourse loan (meaning that the lender’s ONLY remedy in the case of default is to foreclose/repossess the property), then any deficiency above and beyond that amount is not considered taxable. So, is Washington a “non-recourse” state? It is and it isn’t – but for tax purposes, it does not matter. According to RCW 61.24.100(1), a bank cannot obtain a judgment for the deficiency after a typical non-judicial foreclosure. One would assume that this means that Washington law supports the idea that its home loans are non-recourse. But it isn’t that simple.

Washington law affords the lender two pathways to foreclose on property and collect against a homeowner in the event of a breach: a non-judicial foreclosure (where the bank forecloses through the Deed of Trust law, which is by far the most common), or judicial foreclosure (where the bank actually sues the homeowner and compels sale of the property through a Sheriff’s sale). It is this option between the two methods of foreclosure which is key to why homeowners are likely taxed for the deficiency in the event of a foreclosure.

The IRS’s guide described it thus:

A non-recourse loan is a loan for which the lender’s only remedy in case of default is to repossess the property being financed or used as collateral.That is, the lender cannot pursue you personally in case of default. Forgiveness of a non-recourse loan resulting from a foreclosure does not result in cancellation of debt income.

So, while there is a temptation to think that if a bank cancels whatever remaining debt that results from a judicial foreclosure (short sale, deed-in-lieu), one escapes having to report the cancellation as income, it is not the case. Because the banks have the option to pursue either a judicial or non-judicial foreclosure at the time the agreement was entered into, it is likely that the homeowner will be subject to taxation of whatever deficiency was waived or cancelled.

(Please note that this firm is not an accounting firm, nor does it specialize in tax law. The US tax code is complex and the debt cancellation issue is one that is impacted by many other factors which are not discussed here. If you believe you may be facing such an issue, our advice would be to consult with a tax attorney or certified public accountant for clarification.)