The Internal Revenue Service looks at rental properties differently than it looks at your personal residence. With a rental property, you get to deduct expenses against your taxable income. You also have to pay taxes on your gains and can write off your capital losses if you sell for less than you paid. With this in mind, a foreclosure will also be treated differently.
Profitable Foreclosure Sales
If you end up in foreclosure because your property is doing well, but your loan has a balloon payment, and you're unable to refinance it, it's possible you could walk away from the foreclosure with a profit. In that instance, you wouldn't have a loss to write off. Instead, you'd pay taxes on any profit you realize when the bank returns any leftover proceeds to you.
Foreclosure Sales at a Loss
Usually, when you get foreclosed on, you end up losing money on your property. Because your rental is an investment, the foreclosure generates a capital loss. Generally, you can write off up to $3,000 in capital losses against other income on your tax return. However, if you also have capital gains during the year, you can use your loss from the foreclosure to cancel out the gain and the taxes on the gain.
Loan Types and Losses
The amount of your loss depends on your loan type. If your loan is non-recourse, meaning you are not responsible for it after the foreclosure, the IRS considers your loan balance to be your selling price, so your loss would be equal to what comes out of subtracting your cost basis from your loan balance. With a recourse loan that holds you responsible to pay any remaining balance even after the foreclosure, your selling price is the lower of the actual selling price or your loan balance.
Taxable Debt Cancellation
When your rental property gets foreclosed on, and you're responsible for your loan, your lender may forgive your remaining balance. If the lender does this, it won't affect your capital loss write-off. However, the IRS may treat the loan forgiveness as regular income. If your loan doesn't qualify for the qualified real property business indebtedness exclusion, you'll have to pay regular income tax on the amount of the loan that gets written off.
When you depreciate your rental home, the IRS expects to get that depreciation back if you sell your home for more than the balance to which you wrote it down. Depreciation recapture on real estate is taxed separately from your other capital gains, at 25 percent. It's due on the difference between your depreciated basis, which is your cost basis less all of your depreciation, and your selling price, up to your original purchase basis.
For example, if you bought a property for $150,000 and claimed $47,000 in depreciation, the depreciated basis would be $103,000. If you sold for $160,000, you'd owe capital tax on the $10,000 in capital gains and the recapture tax on the $47,000 in depreciation you claimed. If you sold it for $130,000, you'd have a $20,000 capital loss, but owe recapture tax on the $27,000 difference between the selling price and the depreciated basis.
Understanding Your Circumstances
Calculating your tax liability in a rental property foreclosure is a complicated process. Furthermore, when an investor is liable for depreciation recapture and additional income tax for debt forgiveness, the tax liability can run into tens of thousands of dollars. To this end, some investors choose to retain a tax lawyer or a certified public accountant to assist them in understanding what their responsibilities will be.
Steve Lander has been a writer since 1996, with experience in the fields of financial services, real estate and technology. His work has appeared in trade publications such as the "Minnesota Real Estate Journal" and "Minnesota Multi-Housing Association Advocate." Lander holds a Bachelor of Arts in political science from Columbia University.