What is the tax treatment when mortgaged property is sold?
If mortgaged property is sold, the amount realized is the net purchase price, minus the cost basis, whether or not the seller receives any of it. This is consistent with the rule that borrowing money is not taxable.
You purchase an investment property for the amount of $150,000 with $20,000 down and a mortgage of $130,000. After 10 years the mortgage is reduced to $80,000 and the value has increased to $2000,000. You refinance the property and take a mortgage of $160,000 and use the additional money for other investments. Shortly after that you sell the property for $210,000.
You have selling costs of $15,000. The net cash received from the sale is $210,000, minus the $15,000 in selling costs and the mortgage of $160,000, for a net cash total of $35,000. However, $35,000 is not your capital gain. Your capital gain is $210,000, minus selling expenses, minus your cost basis of $150,000 (the amount originally paid for the property). Therefore your taxable capital gain is $45,000, even though the cash received was only $35,000.
Many taxpayers today are running into rather serious problems with investment properties because of the serious housing slump. Many of them refinanced the properties as they increased in value, and used the money for other investments. They may be required to sell their properties because they can no longer manage the mortgages, and they are selling for less than the mortgages, but often still have a taxable gain and the short sales produce cancellation of debt income as well.