How Foreclosures Affect Tax Returns

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The COVID-19 pandemic has caused many financial strains that have seen many default on their mortgage payments. A foreclosure is when one defaults on mortgage payments; then, the lender seizes the mortgaged property even the situation gets worse. If the property has been used to secure more than one mortgages, any lenders can initiate foreclosure, but the first lender is given priority when settling payment.

If your mortgage is a recourse loan, the lender may still follow you up to settle any negative differences after the foreclosure. However, for nonrecourse loans, the lender is only required to take the property and sell it. The lender cannot pursue the borrower if there are any negative differences.

For taxation purposes, two factors are considered to determine foreclosure consequences: the property’s value in relation to the mortgage balance and whether the loan is recourse or nonrecourse.

Recourse Mortgage

When the property’s market value is less than the resource loan balance, the foreclosure is treated as a property sale and triggers a tax gain. In properties, always have their market values less than their recourse loan balance.

However, thanks to the principal residence gain exclusion break, the gains are always federal-income-tax-free. The break applies to unmarried homeowners and allows such homeowners not to pay taxes on gains of up to $250,000. On the other hand, married couples filing their returns jointly can exclude taxes from gains of up to $500,000. To qualify for this tax break, one needs to have owned then home for at least two years of the five years that end on the foreclosure date. The borrower also needs to have used the home as the main home for at least two years of the five years.

Nonrecourse mortgage

For taxation purposes, a nonrecourse lender’s foreclosure is a sale of the property to the lender for the amount equal to the non-recourse loan balance. In this case, the property’s real market value is not considered, and the lender cannot pursue the borrower to settle any negative balances.

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