Capital Gains on Foreclosures
Capital Gains on foreclosures is calculated differently than regular income tax. The sale of property generally goes through an escrow procedure. The sale amount is the amount by which the selling price of the property is less than the balance of the loan. Usually, there is no escrow period associated with foreclosed sales, but the basic formula for computing capital gains is the same. The difference is that the amount realized from the sale of a property is exempt from taxes.
If the property was used as a rental property, the gain is subject to capital gains tax. However, if the foreclosure involves a mortgage loan, the gain will be taxable only if it is used for purchasing another type of property, such as a home. There are special rules for disposing of a deeded interest in a foreclosure property.
Capital Gains on foreclosures generally is not taxable, but if you are able to postpone paying the taxes until after the foreclosure sale occurs, they will become taxable. This applies to most capital gains, although non-recourse loans are not subject to the capital gains tax. For the most part, this is because the lender will be liable for the taxes on any amount that exceeds the outstanding loan balance immediately before the foreclosure sale. In addition, you may be able to postpone paying the taxes until after the final date for the sale if you can demonstrate that the proceeds from the sale would be insufficient to pay the outstanding loan balance immediately. If you can meet this condition, you may be able to delay paying the tax for up to three years.
When you sell a foreclosed property, there is no way to determine whether the proceeds will be sufficient to satisfy your needs, unless you have long-term capital gains tax benefits that exceed the mortgage amount. You cannot deduct the entire mortgage interest from your sale and this will be reflected as a long-term capital gain in your year of income. For most people, the sale of a foreclosed property is their only opportunity to get capital gains tax benefits, and there are several reasons for this. You are selling your primary residence, which is subject to the regular income tax laws. The property is also transferred to a new owner immediately and is not held on the market for the duration of the foreclosure sale, making it technically not your primary residence.
Another reason for capital gains tax relief is that the lender is not liable for income tax on the amount received from the sale. This is known as the non-taxable income element. Capital gains tax is not applied to this element. If you were to apply the funds received to the unpaid income taxes, you could be subject to double taxation.
There are several rules that govern how much of your principal balance will be taxed as well as how much will be taxed against the taxable income element of your total gross proceeds. Because a large portion of your gross proceeds will be exempt from taxation, your taxable income will be lower than it would be if you had more taxable income and less non-taxable income. In addition, you will generally be taxed at a higher rate if the foreclosure is your first sale in many years, rather than if the sale was your first sale in a very short time. If you are considering obtaining a loan to purchase a residential property, you may want to consider one of the many reverse mortgage programs available to taxpayers with adjusted gross equity exceeding the mortgage balance. A reverse mortgage can be used to finance many properties and pay down the mortgage debt, avoiding capital gains taxes when you sell the property or when it is converted into a mortgage.