More Californians confront foreclosure because of mortgage payments that they cannot pay, or interest rate resets that will soon make payments unaffordable.
When foreclosure looms, bankruptcy presents options and alternatives, whether you are keeping the house or not.
Keep the house
If your decision is to try to cure payment defaults and keep the house, Chapter 13 can provide a court enforced repayment plan that brings the mortgage current over time.
You should consider seriously whether it makes sense to keep the house. Sometimes keeping a heavily encumbered house makes neither economic nor emotional sense.
Surrender the house
Many homeowners have several mortgages on their home. Often the creditor who initiates the foreclosure is the holder of the senior mortgage.
If the senior lienholder completes a foreclosure (which destroys any junior liens) the junior mortgage or HELOC lender typically has the right to sue the borrower for the loan balance.
The obligation to that cut off junior lender can be discharged in bankruptcy. More about how foreclosure works.
Tax consequences of foreclosure
An ugly, and often unexpected, follow-on to foreclosure is receipt of an IRS form 1099(c). That form reports the foreclosure sale just as though it was an arm’s length sale.
There are two kinds of tax obligations.
Cancellation of debt income
One kind of tax consequence is based on the cancellation of debt. The difference between the balance owed the foreclosing creditor and the fair market value of the house may be treated as income.
Cancellation of debt income can be excluded from your taxable income if you are insolvent; your personal liability was discharged in bankruptcy; or your home qualifies for the federal tax safe harbor. See IRS on Mortgage Debt Forgiveness Act. More on cancellation of debt income.
Capital gains tax
If you have taken equity out of your property by refinancing or junior liens, a foreclosure sale may trigger capital gains taxes.
Capital gain is calculated by subtracting the property’s tax basis from the sale price. It isn’t dependent on actually receiving cash proceeds upon sale.
If the foreclosed property is a qualifying home, the gain triggered by the foreclosure may be sheltered by the homeowner’s exclusion, which is currently $250,000 for each spouse on title.
In California, where home values have increased dramatically over the past several decades, homeowners have often taken equity out of their homes via refinancing. As a result, there may be substantial taxabale gain in excess of the amount of the exclusion, triggering a tax debt.
A solution to the threat of taxes following a foreclosure may be found in Chapter 7 bankruptcy. The bankruptcy estate created when a case is filed by an individual is itself a taxpayer, separate from the individual. If the foreclosure takes place when the encumbered house is property of the bankruptcy estate, the tax consequences fall to the bankruptcy estate, not the debtor.
It is worth considering a Chapter 7 prior to a foreclosure when the sale is likely to generate taxes.
As you can see, there are a number of complex factors at work in these situations.
An experienced bankruptcy lawyercan help you assess the options and alternative.
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