It almost seems impossible that after undergoing the misfortune of a foreclosure, you could get hit with the “double whammy” of having the Internal Revenue Service insist you pay income taxes or capital gains on the foreclosure transaction. You’ve just had your home taken away from you because you were unable to make all of your mortgage payments on time! How is that a red flag for the IRS? Here’s how it can happen. Your lender originally based your mortgage loan on the value of the property you were buying. When your property is foreclosed, the title changes hands from you to the lender and/or trustee. A new tax assessment is performed. Property values fluctuate, so it’s possible the value of your home has declined since you obtained your mortgage loan. In fact, the trustee will often have to sell it for less than its initial value — and less than the amount you owe — simply to get rid of it and keep from taking a loss. (This is known as an underbid. ) If the lender sells the property for less than it was worth when you bought it, it will look as though a large part of your mortgage debt was forgiven by the lender. In other words, the lender loaned you money that you don’t have to pay back now. To the IRS, that looks like income! It looks as though you’ve benefited from a sizeable windfall, and the federal government may demand its share of taxes for income and capital gains! Some exceptions apply. For example, if you’ve recently gone through bankruptcy or are otherwise dealing with insolvency, you might not be subject to this kind of taxation. This would be an excellent time to consult your accountant or tax attorney to find out whether you’re required to file special paperwork with the IRS and to determine what the impact might be on your individual situation.
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