Jul 272011
 

First, this stuff is complicated.  This is only a tax summary.  Please consult us with your exact facts and do not attempt to do this at home on your own.  If you want to explore this topic more, grab another Cup of Joe and read Publication 4681 found using this link:  http://www.irs.gov/pub/irs-prior/p4681–2008.pdf  However, we love to make this true statement:  The IRS does not make law and their publications are only guidance.

Our nation is now seeing the effects of tightening mortgage credit after a liberal period. With increases in interest rates for adjustable rate mortgages and the conversion to amortization of principal for interest-only (or negative amortization) loans, home values for homes favored by subprime borrowers (and even other homes) have been falling during 2010.  The debtors are either trying to “walk away” from their homes and allowing them to be foreclosed or working with their bank for “short sales”.  Banks in South Carolina have also filed lawsuits against homeowners with recourse mortgages.

A “short sale” is selling the home for less than the mortgage balance and trying to get the lender to forgive the unpaid balance.  Of course, the banks generally control the ability for a debtor to “short sale” a property.  In a short sale or a foreclosure, the indebtedness deemed forgiven would be taxable income without certain exceptions or exclusions.  A reason for debtors to consider a “short sale” instead of a foreclosure is to try to protect their credit history.

How are foreclosures (and deeds in lieu of foreclosure) taxed?

An important consideration with foreclosures (or a deed in lieu of foreclosure) is whether the debt is “recourse” or “nonrecourse”. If the debt is “recourse”, the debtor is personally liable for the debt. If the debt is “nonrecourse”, the debt is only secured by the property.  The debtor is not personally liable for the balance unless there is a separate personal guarantee by the debtor.

You should consult with an attorney to determine the status of your mortgage. In South Carolina, most mortgages that are used to purchase a residence are recourse and mortgages from refinancing a previous mortgage are usually recourse but again check with your attorney first.

When a nonrecourse mortgage is foreclosed, the property is treated as being sold for the balance of the mortgage. This is important because the gain from a foreclosure of a principal residence may be eligible for the $250,000 ($500,000 for jointly-owned marital property) exclusion.

For example, for foreclosure of a nonrecourse debt:

Nonrecourse debt

$500,000

Tax basis (cost to determine tax gain or loss)

  300,000

Gain

$200,000

If the holding period requirements are met (2 years) and the residence was a principal residence, the above gain would be tax-free entirely because of the gain on the sale of primary residence exclusion.

For recourse debt, the debt is only satisfied up to the fair market value of the property. So, there is deemed a sale up to that amount. If the lender forgives the balance of the mortgage, there is cancellation of debt income, which is taxed as ordinary income. For example, for foreclosure of a recourse debt:

Recourse debt

$500,000

Fair market value

  450,000

Cancellation of debt (ordinary income)

$ 50,000

(If the cancellation of debt was for “qualified principal residence indebtedness” (important see below), it will be excluded from taxable income. If the taxpayer still owns the home after the cancellation of debt, the excluded amount will be subtracted from the tax basis of the residence. See the section on “tax relief”, below.)

Fair market value

$450,000

Tax basis

  300,000

Gain

$150,000

Again, if the holding period requirements are met and the residence was a principal residence the above gain would be tax-free, but the cancellation of debt would generally be taxable as ordinary income, except for certain “qualified principal residence indebtedness”. See the section on “tax relief”, below.  Even though the total gain in this example is the same as the previous example (i.e…$200,000), the first $50,000 of gain is excluded because of the tax relief provision discussed below and the remaining $150,000 escapes tax because of the gain on the sale of primary residence exclusion.

Tax relief enacted for recourse mortgage on principal residence debt forgiveness.

Congress has passed and President Bush has approved H.R. 3648, the “Mortgage Forgiveness Debt Relief Act of 2007”. The legislation is effective for discharges of indebtedness on or after January 1, 2007 and before January 1, 2010. The Federal Bailout Legislation H.R. 1424, passed on October 3, 2008, extended this relief through December 31, 2012.

Under the new law, a discharge of “qualified principal residence indebtedness” is excluded from taxable income. “Qualified principal residence indebtedness” is acquisition indebtedness secured by the principal residence of a taxpayer as defined for the deduction of residential mortgage interest, but the limit is $2,000,000 for the exclusion ($1,000,000 for the mortgage interest deduction) and $1,000,000 for married persons filing a separate return ($500,000 for the mortgage interest deduction). Also, the exclusion only applies to a mortgage secured by the principal residence of the taxpayer.

We think it is more important to understand what does not qualify as “qualified principal residence indebtedness”.  “Qualified principal residence indebtedness” is not mortgages on rental properties, mortgages on second homes or equity lines.  In addition and importantly, if you refinanced or secured a second mortgage and used the excess proceeds (if any) for anything other than home improvements, the allocated indebtedness is not “qualified principal residence indebtedness”.  Mortgage balances exceeding $2,000,000 (assuming joint filing) do not count either should you be lucky enough to have this problem.  This type of indebtedness called “disqualified debt” for tax purposes.

Disqualified debt is taxable first!

An “ordering rule” in the tax law says that the exclusion only applies to as much of the amount discharged as exceeds the amount of the loan which is not qualified principal residence indebtedness.

For example, Julie Smith’s residence was foreclosed in 2008. The fair market value of her home was $200,000. The balance of her mortgage was $275,000. Julie had used $50,000 from refinancing her home to pay down her credit card debt, not for home improvements. $50,000 of the debt discharge that is not qualified residence debt would be taxable, and the remaining $25,000 that is qualified residence debt would be excluded from taxable income.

Another example, the residence of John and Mary Taxpayers was foreclosed in 2008. The fair market value of their home was $1,500,000. The balance of their mortgage, which was all acquisition indebtedness, was $2,250,000. Since the maximum qualified principal residence indebtedness is $2,000,000, $250,000 of the debt was not qualified principal residence indebtedness. The $250,000 non-qualified debt cancellation would be taxable income, and the remaining $500,000 that is qualified indebtedness would be excluded from taxable income.

Amounts that are otherwise taxable in the above examples could qualify for exclusions under other exceptions, such as for insolvency or bankruptcy.

What happens with a “short sale”?

Short sales are taxed under the same rules as foreclosures.

Recourse debt cancellation is not satisfied with the surrender of the property, so any debt not satisfied with the sale proceeds would be taxable as cancellation of debt income, except for certain “qualified principal residence indebtedness”. See section on “tax relief” above.

Therefore, the tax consequences would be similar to the “recourse debt” example, above. The buyer and seller might also have legal concerns about whether the lender would consent to the transaction and whether (for recourse debt) the lender would in fact forgive the debt.

For example, for a recourse debt short sale:

Net sale proceeds

$450,000

Tax basis

  300,000

Gain

$150,000

 

Debt

$500,000

Pay off using net sale proceeds

  450,000

Cancellation of debt (ordinary income)

$ 50,000

(If the cancellation of debt was for “qualified principal residence indebtedness”, it will be excluded from taxable income and be subtracted from the tax basis of the residence. See the section on “tax relief,” above.)

For non-recourse debt short sales when the seller and buyer require the cancellation of the debt by the lender as a condition of the sale, the debt cancellation is included in the sale proceeds, like for a foreclosure.

Therefore, a “short sale” can be a viable alternative to a foreclosure for debtors with nonrecourse debt and who qualify for the exclusion from income of the gain from the sale of a principal residence.

What about selling expenses for a recourse mortgage?

For simplicity, we have disregarded selling expenses in the above discussion. For a short sale, selling expenses reduce the sales proceeds available to reduce the loan. For a foreclosure or deed in lieu of foreclosure, selling expenses are added to the debt. The net result should be similar; assuming the fair market value of the property equals the selling price for a short sale.

For example, for foreclosure of a recourse debt,

Recourse mortgage balance

$500,000

Selling expenses

    50,000

Total debt

$550,000

Fair market value

  450,000

Cancellation of debt (ordinary income)

$100,000

(If the cancellation of debt was for “qualified principal residence indebtedness,” it will be excluded from taxable income. According to IRS Publication 4681, if the cancellation of indebtedness happened relating to a short sale, no basis adjustment would be required. If the taxpayer still owned the home after the debt cancellation, the exclusion amount would be subtracted from the tax basis of the residence. See the section on “tax relief,” above.)

Fair market value

$450,000

Tax basis

-300,000

Selling expenses

   -50,000

Gain

$100,000

 

For example, for a recourse debt short sale:

Sales price

$450,000

Selling expenses

-50,000

Tax basis

 -300,000

Gain

$100,000

 

Recourse mortgage balance

$500,000

Pay off using net sale proceeds
($450,000 sales price – $50,000
selling expenses)

  400,000

Cancellation of debt (ordinary income)

$100,000

(Same caveat for “qualified principal residence indebtedness” as above.)

Other exceptions for cancellation of debt income:

Cancellation of debt income may not be taxable if the debtor is insolvent or has the debt discharged in bankruptcy. With the recent changes in the federal bankruptcy laws, it is much harder for individuals to file bankruptcy than before the changes.  You do not have to file for bankruptcy in order to qualify for insolvency under tax law!!!

Senator Grassley asks IRS to help homeowners with loan forgiveness tax bills.

Senator Chuck Grassley, R-Iowa, who is the ranking minority member on the Senate Finance Committee, has sent a letter to the Treasury Department and the Internal Revenue Service asking for help for homeowners who face big tax bills because of home loan debt forgiveness on a principal residence. Grassley asked that the IRS accept offers in compromise to eliminate or reduce the taxes for these transactions.  So, if you think you are stuck with a taxable gain, call us. 

Summary: 

Taxability of Short Sales and Foreclosures are very similar and avoidable in most cases.  If you have a gain from either type of transaction, you can generally use one of these exceptions/exclusions to avoid immediate tax:

  • Qualified principal residence indebtedness
  • Mortgage Forgiveness Debt Relief Act of 2007
  • Insolvency or Bankruptcy

However, it you used certain mortgage proceeds for personal reasons other than home improvements to your primary residence subject to the debt forgiven, you may have ordinary taxable income on that amount.  Insolvency or bankruptcy can also be used in this case to escape tax.

If the indebtedness is not qualified principal residence indebtedness, you may have a full taxable gain.

IRS Circular 230 Disclosure: As required by U.S. Treasury Regulations, you are hereby advised that any written tax advice contained on this website was not written or intended to be used (and cannot be used) by any taxpayer for the purpose of avoiding penalties that may be imposed under the U.S. Internal Revenue Code.