Foreclosures and Mortgage Forgiveness Relief
If a lender forecloses on my principal residence or agrees to a short sale, will I owe tax on the deficiency?
The tax consequences for foreclosure are a second hit for people who have had to walk away from their homes. If their lender forecloses on their homes or accepts an amount less than the loan balance from sale of the home, it may result in taxable gain to the homeowner.
For federal and state tax purposes, gross income generally includes income from whatever source derived, including gains from dealings in property. Gain in connection with the sale or exchange of property is the excess of the amount realized on the sale or exchange over the adjusted basis of the property. The amount realized from the sale or disposition of property is equal to the total of any money received plus the fair market value (FMV) of other property received.
Tax on This Seemingly "Phantom" Type of Income
If a taxpayer borrows money from a commercial lender and the lender later cancels (forgives) the debt, the taxpayer may have to include the cancelled amount in income for tax purposes. When the taxpayer borrowed the money, the loan proceeds were not required to be included in income because the taxpayer had an obligation to repay the lender. When that obligation is subsequently forgiven, the amount received as loan proceeds is reportable as income because there is no longer an obligation to repay the lender. The lender is usually required to report the amount of Cancellation of Debt (COD) to the taxpayer and the IRS on a Form 1099-C, Cancellation of Debt.
A transfer of property from foreclosure or a deed in lieu of foreclosure is treated as a sale or exchange for tax purposes. The amount realized from the transaction depends on the FMV of the property and whether the debt on the property is a recourse debt or a nonrecourse debt. A recourse debt is a secured debt for which the leader’s only recourse is to take the property securing the debt and the borrower is personally liable; a nonrecourse debt is a debt where the borrower is not personally liable.
The tax treatment of the gain will depend on whether the mortgage is considered non-recourse or recourse debt.
In any sale or exchange of property subject to nonrecourse indebtedness (including a foreclosure sale or a transfer by deed in lieu of foreclosure), the amount realized includes the balance of the nonrecourse indebtedness. Consequently, the borrower will recognize gain to the extent the amount realized (including the full amount of the nonrecourse indebtedness) exceeds the adjusted basis of the property. The FMV of the property is irrelevant. In addition, the borrower will recognize no income from discharge of indebtedness.
In a sale or transfer of property subject to recourse indebtedness to a creditor (including a foreclosure sale or transfer by deed in lieu of foreclosure), the transaction is split into two transactions:
- A sale or exchange of the property for its FMV.
- To the extent the FMV of the property is less than the outstanding recourse indebtedness, either a continuing obligation to pay or income from the discharge of indebtedness.
In California, purchase money mortgages, which are mortgages where the borrowed funds are used to purchase the persons house, are generally treated as nonrecourse debt. If the bank forecloses on a nonrecourse mortgage, then the homeowner is treated as having sold the home for the amount of the outstanding debt. The difference between the outstanding debt and the homeowner's adjusted basis in the house is considered a gain or loss on the sale of the home. If the home is the taxpayer's principal residence, where they have lived for at least two of the past five years, the gain may be eligible for the gain exclusion on the sale of a principal residence. If the foreclosure results in a loss, the loss may not be taken since it resulted from the sale of a
If the mortgage is recourse, any foreclosure may result in a gain on the sale of the house, and/or cancellation of debt income. The difference between the FMV of the house and the owner's adjusted basis will result in a gain or loss on the sale of the home. If the outstanding debt exceeds the house’s FMV, the amount is treated as cancellation of debt income. Any gain on the portion treated as the sale of a personal residence may be eligible for the exclusion on the sale of a principal residence; however, as discussed above, the loss may not be taken on the sale. The portion that is treated as cancellation of debt income is taxed as ordinary income - subject to ordinary income tax rates. Relief of debt is considered income because the bank gave the buyer cash to purchase the home when it issued the mortgage. This cash was not taxable because it was a loan, and the buyer promised to repay it. When the loan is forgiven or canceled, it becomes income in that year since the buyer will no longer repay it.
Mortgage Forgiveness Relief
For federal purposes, the American Taxpayer Relief Act of 2012 extended the COD exclusion for principal residence debt through 2013. This Act generally provides for an exclusion from gross income for qualified debt forgiveness on a principal residence, up to a maximum of $2 million. California does not conform to this exclusion. This means that a homeowner who loses a home to foreclosure in 2013 may not use the principal residence exclusion to exclude COD income on his or her California return.
When COD Income is Taxable
While COD income is generally includable as taxable income, there are a couple of options for your clients who are caught in this situation:
Debts discharged in bankruptcies are generally not considered debt-cancellation income.
Tax will not be assessed on the debt-cancellation income if your client can prove insolvency existed when the debt was discharged. California conforms to the insolvency provision, even if the taxpayer uses the federal principal residence exclusion on their federal return. If a taxpayer is insolvent when the debt is cancelled to the extent of the insolvency, some or all of the cancelled debt may not be taxable. A taxpayer is insolvent when the taxpayer’s total debts are more than the fair market value of the total assets determined immediately before the discharge. Your client must prove that all assets totaled less than all debts.
The excluded amount is applied to reduce tax attributes in the order listed on Federal Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment). However, an insolvent taxpayer may elect to apply all or a portion of the excluded amount first to reduce basis in depreciable assets or in real property held as inventory, rather than to reduce the tax attributes.
For more information on the basis adjustments, see the instructions for Federal Form 982. California does not have its own version of Form 982. When using different elections on the federal and California return, create a separate Form 982 for the California return listing the exclusions that were used on that return, along with any basis adjustments.
If the foreclosure occurred outside of bankruptcy, the taxpayer is solvent, and/or is not a C corporation; they may elect to exclude cancellation of Qualified Real Property Business Indebtedness (QRPBI) income if certain requirements are met (IRC section 108(c)). Under California law, if a taxpayer makes an election for federal income tax purposes, where California conforms to or incorporates the underlying federal tax law that election is binding for California income tax purposes. No separate California election is allowed.
If you make an election to exclude canceled qualified real property business debt from income, you must reduce the basis of your depreciable real property (but not below zero) by the amount of canceled qualified real property business debt excluded from income. The basis reduction is made at the beginning of the year. However, if you dispose of your depreciable real property before the beginning of the year, you must reduce the basis of the depreciable real property (but not below zero) immediately before the disposition.
If your reporting position is audited by California, you should be prepared to provide documentation and an analysis of your facts in support of your position.
More information regarding foreclosures and short sales is available at irs.gov.