Despite the growing number of property owners participating in a short sale, loan modification, deed in lieu or foreclosure, there is still quite a bit of confusion regarding the tax consequences for borrowers. Forgiveness of debt, in full or in part, is typically approved by short sale lenders and occasionally following foreclosures. Debt forgiveness is certainly welcomed by most borrowers but unfortunately may result in harsh tax consequences.
If a lender chooses to release a borrower from some, or all, of an outstanding loan obligation, it is required to issue a Form 1099-C which reports the cancellation of debt. Although the borrower is not receiving cash, the IRS considers the extinguished debt obligation to be taxable income. In order to understand the problem and the potential solutions, it is important to understand the reason that forgiven debt is treated as income. At the time the loan was made, the loan proceeds were not included in the taxable income of the borrower because there was an obligation to repay the loan. However, when the debt is forgiven, the obligation to repay the loan goes away, and taxable income is triggered. For example, if the seller borrowed $300,000, the lender receives $200,000 in proceeds from a short sale and forgives the remaining $100,000 balance, the IRS’ position is that the seller has $100,000 of income that no tax has been paid on. IRS does not consider the fact that the loan proceeds were “spent” on the property, which has lost value. The result is phantom income, meaning that the seller has not received cash from the sale proceeds with which to pay the tax. The amount of debt forgiven by lenders, particularly in short sales, can be substantial, and may result in unexpected taxable income and higher tax rates.
To provide some relief to struggling homeowners potentially facing crippling tax liability, Congress passed the Mortgage Debt Forgiveness Relief Act (the “Act”) in December of 2007. The Act offers relief to borrowers by excluding some or all of the forgiven debt from taxable income, subject to certain conditions. To be eligible, a borrower must establish that the debt forgiven was incurred to purchase, construct, or substantially improve the borrower’s principal residence, as defined in Internal Revenue Code Sections 121 and 163(h). A further limitation of the Act holds that the exemption only applies to the first $2 million of debt released. The Act has been extended several times, but is currently set to expire December 31, 2012. Congress has not yet indicated whether it will again be extended.
Borrowers often mistakenly believe that a Principal Residence, as defined by the IRS, is synonymous with a homestead, as defined by Florida law. However, one should never assume that a designated homestead will qualify as a Principal Residence for IRS tax purposes. A Florida homeowner has the ability to designate their newly purchased property as their homestead as soon as they begin to occupy the property as their main home, whereas property may only be considered a Principal Residence if the residence has been owned and occupied by the homeowner as their main home for at least two of the last five years immediately preceding the date the debt is forgiven. In the context of a short sale, the date the debt is released may or may not be the date of closing as, in some instances, the deficiency is negotiated after completion of the short sale.
As stated above, to qualify for relief provided by the Act the loan proceeds must have been used for the purchase, construction, or substantial improvement of the property. This requirement disqualifies debt, or any portion thereof, incurred and used for any other purposes, such as vacations, business investments, or to pay off credit cards or car loans. This is especially problematic where homeowners obtained home equity lines of credit (HELOC) or second mortgages which could be used for any purpose.
Cancellation of debt income, when exclusions do not apply, can cause other complications to the seller’s tax return as well. Not only is additional taxable income a possibility, but the result may also be an adjustment in tax rate or bracket, which can phase the taxpayer out of certain deductions they are accustomed to taking. Although one may traditionally fall into a lower tax bracket, cancellation of debt may substantially increase a seller’s taxable income and their total income could be taxed at a higher tax rate. It is not uncommon to see as much as $150,000, or more, granted in debt forgiveness which could easily result in a higher tax rate for many borrowers.
The Internal Revenue Code also provides for an insolvency exclusion which exempts forgiven debt for a taxpayer, to the extent of their insolvency. Insolvency is the difference between the taxpayer’s outstanding liabilities and the fair market value of all assets held on the date of sale or debt forgiveness. To the extent that the taxpayer’s liabilities are greater than the value of the assets, that difference can be used to exclude cancellation of debt income from taxable income. For example, assume the taxpayers liabilities, including the mortgage debt forgiven, total $500,000 and the fair market value of all the assets, including the property sold, total $400,000. The difference ($500,000-$400,000) of $100,000 is the extent of their insolvency. That means up to $100,000 of 1099-C income can be excluded from taxable income. Assets used in this calculation include creditor protected assets, such as retirement accounts. A borrower should never assume that they qualify for this exemption by virtue of the fact that there is negative equity in their home. To determine eligibility for the insolvency exclusion, a detailed analysis of a taxpayer’s assets and liabilities would need to be performed. Unlike the exemption provided by the Act, this exclusion is available for investors.
Lenders are required by law to report on Form 1099-C any release of debt greater than $600 and have no discretion to withhold such information. The resulting tax liability occurs upon the release of loan obligation, not upon the issuance of the 1099-C. Not only does the lender have a reporting obligation, but the borrower must also report this liability on their tax return for that year. Failure to do so can result in a 25% underreporting penalty and an increased audit period from three to six years.
Some borrowers believe that foreclosure may allow them to circumvent tax liability, but release of debt may occur following completion of a foreclosure. Again, the borrower has no ability to request the lender not issue the 1099-C, and if the lender chooses to release the debt following the foreclosure action, either on its own accord or in response to post-deficiency negotiations, the debt forgiven will likely be much larger and the incidental tax liability much greater due to the additional costs and fees that accumulate and grow the balance of a loan throughout a foreclosure action.
Borrowers also believe bankruptcy to be a potential solution to tax liability. This may be accurate depending upon when the borrower files bankruptcy. Income tax liability is not typically dischargeable and if the forgiveness of debt occurs prior to the bankruptcy filing, it will likely remain.
Tax consequences resulting from short sales, loan modifications, and foreclosures are fact specific and should always be evaluated by a professional. In many cases, tax planning can help a seller legally avoid or minimize the tax consequences of their transaction. If the seller proceeds without planning for the tax impact of the transaction, they are often unpleasantly surprised with the outcome.