Determining Tax Consequences of Foreclosures

February 2009 (reprinted from the Ventura County Star)
By Maria Capritto

Foreclosure has become a household word, but many people think they can simply walk away from their home once the process is complete. When a lender forecloses on property, the owner may have to report income from the foreclosure, as well as capital gain, on a federal income tax return. Foreclosure may result in a reportable gain because foreclosures are treated like sales for tax purposes.

Whether or not the foreclosure generates taxable income depends on the facts and circumstances of each person’s particular situation. Before foreclosing, homeowners should know the federal income tax consequences.

Cancellation of Indebtedness Income

The Mortgage Forgiveness Debt Relief Act of 2007 was enacted on Dec. 20, 2007. Generally, the act allows taxpayers to exclude up to $2 million of forgiven debt ($1 million if married filing separately or single) from taxable income related to the discharge of “qualified principal residence indebtedness.” This is defined as acquisition indebtedness secured by the principal residence of a taxpayer where the debt was used to buy, build or substantially improve the principal residence. Debt incurred from the refinancing of loans qualifies for this exclusion, but only to the extent that the principal balance of the old mortgage, immediately before the refinancing, would have qualified for the exclusion. The act applies to debt forgiven in 2007, 2008 or 2009.

The lender usually reports the amount of cancelled debt to the owner and to the Internal Revenue Service on Form 1099-C Cancellation of Debt. The cancellation of debt does not always cause discharge of indebtedness income even if the owner does not qualify for relief under the act. Under certain circumstances, cancellation of indebtedness is not considered to be taxable income. The exceptions are:

• Bankruptcy — Debts discharged through bankruptcy are not considered to be taxable income;
• Insolvency — If the taxpayer is insolvent when the debt is cancelled, some or all of the cancelled debt may not be taxable. A taxpayer is insolvent if the total amount of debt exceeds the fair market value of total assets.
• Cancellations of certain farm debts are not considered to be taxable income;
• Non-recourse loans — Forgiveness of a non-recourse loan resulting from a foreclosure does not result in cancellation of indebtedness income. In California, most mortgages related to the purchase of a residence are non-recourse, but mortgages from refinancing a previous mortgage are usually recourse.

Gain from foreclosure

Because a foreclosure is treated as a sale for tax purposes, the taxpayer also must determine if there is a taxable gain to report as a result of the foreclosure. If the property is used as the principal residence for periods totaling at least two years during the five-year period ending on the date of foreclosure, the taxpayer may exclude up to $250,000 (up to $500,000 for married couples filing a joint tax return) from income. If the taxpayer does not qualify for this exclusion, or if the gain exceeds the exclusion amount, then the taxpayer should report the gain on Schedule D as a capital gain.

Gain from foreclosure is calculated by comparing the fair market value of the property (for non-recourse loans, use the amount of the debt immediately prior to the foreclosure) to the adjusted basis in the property. Adjusted basis is usually the purchase price plus the cost of any major improvements to the property. If the fair market value or non-recourse debt amount is greater than the basis, then there is a gain on the foreclosure that may or may not be reportable depending on whether or not the taxpayer qualifies for exclusion of the gain if the property was the principal residence. Unfortunately, if this calculation results in a loss from the foreclosure, the loss is not deductible on a personal income tax return.

Short sales

Short sales are taxed under the same rules as foreclosures. A short sale occurs when a property owner sells the property for less than the amount of the mortgage balance and attempts to convince the lender to forgive the unpaid debt balance.

The lender has three ways to handle the deficiency balance:

• The lender may attempt to collect the deficiency balance from the seller after the sale has closed. This occurs for recourse loans.
• The lender may require the seller to sign an unsecured promissory note for the deficiency balance as a condition of agreeing to the short sale. If the new promissory note is for less than the deficiency balance, the difference may be considered cancelled, or forgiven debt; or
• The lender may agree to cancel the entire deficiency balance.

Because foreclosing can be complicated, it is important to consult a tax advisor or attorney to assist with the foreclosure.

Maria Capritto is a partner with Nordman Cormany Hair & Compton LLP in Oxnard.