If you are in foreclosure, in default on your loan, or have little or no equity in your home, you should know how a foreclosure may affect you. A foreclosure of your house exposes you to three potential areas of liability: credit liability, deficiency liability, and tax liability. Your individual circumstances must be analyzed in view of the following general sources of potential liabilities:
Credit Liability. A foreclosure, as well as any delinquent payments prior to the foreclosure, will show up on your credit report. A foreclosure is a public record and credit reporting agencies will report it on your credit report, where it will remain for up to seven years. The foreclosure will make it difficult but not impossible for you to obtain credit in the future depending on the reason for the foreclosure. For example, if the foreclosure occurred because of destruction to the property by a natural disaster or loss of employment or serious illness by the borrower, it might lessen the impact of the foreclosure when applying for credit in the future. Under federal law, you have a right to have an explanation entered into your credit report and you should do so if there were extenuating circumstances which caused the foreclosure.
Deficiency Liability. A deficiency occurs when the property sells at the foreclosure for less than the amount of the loan balance. For example, if the loan balance is $200,000 and the foreclosure sale amount is $175,000, there is a deficiency of $25,000 for which the borrower is potentially liable. Fortunately, for a complex set of legal and accounting reasons, there is rarely a deficiency in a residential foreclosure and even if there is it unlikely to become an obligation enforceable against the borrower. For example, in California most lenders, when bidding at the foreclosure sale on their loan, will 'credit bid' all or nearly all of the loan balance regardless of the actual value of the property. Furthermore, California has .anti-deficiency' protection for the borrower in Code of Civil Procedure 580d which prevents the lender from obtaining a deficiency after a foreclosure of residential property under a deed of trust. Since most foreclosures of residential property occur under a deed of trust (and not a judicial foreclosure) there is no liability for a deficiency.
Tax Liability. The tax liability caused by a foreclosure is often overlooked by borrowers and is the source of much misinformation. The tax rules are complex, and subject to interpretation, but the following general principles seem clear:
A foreclosure is treated as a sale by the IRS and you will receive a Form 1099 for the amount the lender or a third party bids at the foreclosure sale. Like any sale, it can cause tax liability to the borrower if you have realized gain from the sale. For example, you may have 'gain" from a prior sale where you 'rolled over" the gain from the sale of your previous residence into your current residence that is now being foreclosed, or if you refinanced your house and took cash out, or if you had an equity line of credit or a second deed of trust where you had an outstanding loan balance. The rules are complex and you should consult a specialist. This is a trap for the unwary because it is difficult for most people to believe that they may pay tax on an house that they lose through foreclosure.
Even if there is no foreclosure, you may also incur tax liability if you agree to give a 'deed in lieu of foreclosure" to your lender or if your lender agrees to a "short sale" or a "short payoff." This occurs because the foregoing results in ' debt forgiveness" and may result in taxable income to you! Again, the rules are complex and you need to have a specialist apply the rules to your particular circumstances.
On the other hand, you may have no tax liability from a foreclosure if you don't fit into any of the above categories or you have an offset from a casualty loss such as earthquake or flood damage. Even if you have tax liability there may be ways to minimize or eliminate it through careful planning. The important thing is to analyze your tax liability before the foreclosure occurs.
Summary. You can mitigate the credit, deficiency, and tax liability of a foreclosure by careful planning and analysis before the foreclosure occurs. In some circumstances, it may be preferable to allow a strategically planned foreclosure to occur rather than spend money on loan payments that you may never recover from a sale of your house. You must do a cost-benefit analysis of keeping the house versus allowing a foreclosure in view of the potential liabilities discussed above.