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Let’s Talk About Foreclosure Basics

February 5, 2011

Lots of foreclosures are still going on, and the trend will probably continue until there’s a major improvement in the economy. Who knows when that will happen? A real estate foreclosure occurs when a mortgage borrower defaults and the mortgage lender seizes the mortgaged property in order to sell it and thereby collect as much of the outstanding debt as possible. When there are several mortgages against the property, any of the mortgage lenders can potentially initiate foreclosure proceedings.

The foreclosure transaction is not necessarily the end of the story if the mortgage is a recourse loan. With a recourse mortgage, the lender can pursue the borrower for any negative difference (deficiency) between the foreclosure sale proceeds and the loan balance plus foreclosure costs. Sometimes it takes many months or even several years before the borrower finally learns his or her fate. In contrast, when the mortgage is a nonrecourse loan, the lender’s only remedy is to seize the property and sell it. If there’s a deficiency, it’s strictly the lender’s problem because the lender can’t go after the borrower to collect it.

In some states, first mortgages taken out to acquire principal residences are nonrecourse, but second mortgages are recourse. In this scenario, the second mortgage can initiate foreclosure proceedings and pursue the borrower for any deficiency on the second, but the first mortgage lender cannot pursue the borrower for any deficiency on the first.

Deed in Lieu of Foreclosure: sometimes the borrower and lender will mutually agree on a so-called deed in lieu of foreclosure transaction. This is a voluntary deal on both sides, and it can be beneficial for both sides because the legal costs of a full-fledged foreclosure are avoided. For the borrower, the tax consequences of a deed in lieu of transaction and a regular foreclosure are the same.

For the borrower, the main variable in determining the federal income tax consequences of a foreclosure is whether the mortgage loan is recourse or nonrecourse.

  • Recourse mortgage: when the property is worth less than the loan balance (the most common situation), the tax rules treat the foreclosure as a sale of property for its FMV. Therefore a tax gain will be triggered if the property’s FMV exceeds it basis. However with a principal residence loan, the borrower can often exclude the entire gain under the Section 121 home sale gain exclusion rules. If the property’s basis exceeds the FMV, the foreclosure will trigger a nondeductible loss in the case of a personal residence.
  • Recourse mortgage: when the property is worth more than the loan balance (a rare situation), the foreclosure is treated as a deemed sale of the property for the loan balance plus any additional proceeds the borrower received from the foreclosure sale. However, if the costs of the foreclosure proceedings and sale are large enough to result in a deficiency, you then fall back under the aforementioned rules that apply when the property’s FMV is less than the loan balance.
  • Nonrecourse mortgage: the property’s value is irrelevant when the property subject to a nonrecourse loan is foreclosed by the nonrecourse lender, the foreclosure is treated for tax purposes as a deemed sale of the property to the lender for proceeds equal to the nonrecourse loan balance. A tax gain will be triggered if the nonrecourse loan balance exceeds the property’s basis. However, with a principal residence loan, the borrow can often exclude the entire gain under the Section 121 home-sale gain exclusion rules.

Let GAI (www.gunwel.com) help you distinguish whether you have a  “recourse” or “nonrecourse” mortgage. We can help you with all aspects of your financial life. Call us at 212-979-6830 or stop by for a visit. Tax time is here and we are ready to file your tax returns! See you soon!

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