Mortgage Over Basis Considerations for Foreclosure Properties

Taxable Capital Gain on Foreclosure of Real Estate

Taxable capital gains for income tax purposes result from a short sale, foreclosure or deed in lieu-of-foreclosure of a real property if the outstanding mortgage loan secured by the real property exceeds the investor's adjusted tax cost basis in said property.  This is often referred to as mortgage over basis or mortgage over adjusted cost basis.

This taxable gain resulting from mortgage over basis occurs because the conveyance of the real estate to the bank either through short sale, foreclosure or deed-in-lieu of foreclosure is treated as if the real estate was sold (a forced sale, if you will) to the bank at the real property's fair market value ("FMV"). 

Recourse or Nonrecourse Debt

The determination as to how much taxable gain would actually be realized and recognized, and the exact character of the taxable gain depends on whether the outstanding mortgage debt is recourse (e.g., a loan for which the borrower is personally liable) or nonrecourse (e.g., a loan for which the borrower is not personally liable).  (It should be noted that many of the original tenant-in-common investment properties used nonrecource debt). 

If the outstanding mortgage loan is recourse debt, the investor is treated for income tax purposes as:

(i) having cancellation of indebtedness income (debt forgiveness) to the extent that the outstanding mortgage balance exceeds the fair market value of the property; and

(ii) a capital gain or loss equal to the difference between the actual fair market value of the real property and the investor's adjusted tax cost basis.

In the outstanding mortgage loan is nonrecourse debt, then the investor recognizes a capital gain equal to the difference between the mortgage debt and the investor’s tax cost basis in the real property. In a nonrecourse analysis, the fair market value of the property is treated as not less than the outstanding nonrecourse outstanding debt balance.