PLAN AHEAD….BEFORE FORECLOSURE OR SHORT SELLING

In these tough economic times, many homeowners are finding themselves face to face with a foreclosure.  Some homeowners are fortunate enough to be in a position to transfer their property under a “Short Sale” where the buyer, seller and lender(s) all work together to obtain a fair resolution.  Regardless of your personal situation, you need to be aware of the tax consequences of cancellation of all or part of your real estate debt.

MORTGAGES AND FORGIVEN DEBT

The Mortgage Forgiveness Debt Relief Act of 2007 may provide relief and allow you to exclude from federal taxable income certain debt that is forgiven through foreclosure or short sale.  In order to qualify under this Act, the debt discharged must be debt against your personal residence.  Equity debt or restructuring debt can also be included in the debt eligible for this exclusion, as long as the debt was used to buy, build or substantially improve your home.  This is also referred to as “qualified principal residence indebtedness”.

The final tests to see if you can qualify under this Act are the timing of the forgiveness and the amount of your debt.  The Act applies to debt forgiven between 2007 and 2012 on a maximum amount of $2,000,000 ($1,000,000 if you are married filing a separate return).

CALIFORNIA TAX LAW

California does not automatically conform to the Mortgage Forgiveness Debt Relief Act of 2007.   The most recent California  In California, the debt relief must have occurred in 2007 or 2008, only.  The maximum amount of personal residence debt allowed in the computation is $800,000 ($400,000 for married filing separately) and the maximum amount of debt reduction to be excluded from income is $250,000 ($125,000 for married filing separately).  There is currently no provision for the exclusion of debt reduction in taxable income for 2009. law allows for a modified version of the federal law.

FEDERAL LAW AND OTHER TYPES OF DEBT REDUCTION

The above discussion was limited to qualified principal residence indebtedness.  However, some folks are looking at foreclosure or short sale possibilities on investment property. 

There are five situations where a cancelled debt does not have to be reported as income:

1. Bankruptcy – the debt was already discharged through a bankruptcy proceeding.
2. Insolvency – your total debts exceed your total assets at the time your debt was settled or deemed non-collectable.
3. Indebtedness due to a qualified farm expense.
4. Indebtedness due to certain real property business losses
5. Discharge of your debt was treated as a gift (You owed Mom $5,000 and she said “Don’t worry… consider it a gift).

Insolvency will probably be the most used of the five situations outlined.

You are considered insolvent when, and to the extent, your liabilities exceed the fair market value of your assets.  If you qualify under the insolvency rules, all or a portion of your forgiven debt may be excluded from your taxable income.

For example, if the amount of debt forgiven is $100,000, but your net worth is only $5,000 (after the relief of this debt) you will only include $5,000 as taxable income.  Or, using the same amount of debt forgiven ($100,000), but your net worth after the debt relief is $0, you will not include any debt relief as taxable income.

SECURED DEBT WITHOUT PERSONAL LIABILITY

The IRS currently says sellers who are not personally liable for a debt will realize an amount that includes the full canceled debt, even if the value of the property that is security for the debt is less, which can be offset depending on your adjusted basis in the property.  Purchase money loans secured by real property in California may not carry any personal liability.

For example, Joe buys a home for $300,000.  At the time of purchase, he makes a down payment of $30,000 and secures a purchase money loan of $270,000.  At the time Joe stops making payments, the original loan is down to $260,000.  After foreclosure, the bank is able to sell the property for $200,000.  Even though Joe has debt relief of $260,000 (the amount of debt at the time of foreclosure) he has a basis in his property of $300,000 (original purchase price).  The difference between $260,000 and $300,000 produces a $40,000 realized loss.  Whether or not this loss will be allowed as an offset on Joe’s tax return will depend on the other elements of income in the year of foreclosure as well as the nature and use of the property (i.e. there are currently no losses allowed on the disposition of a personal residence).

SUMMARY

Every situation is unique.  If it appears that your debt relief might be excludable from taxable income due to one of the above exceptions, you should still consult your tax adviser for an opinion specific to your situation.  If you think that all is lost and you will pay taxes on your debt relief, then you definitely need to consult your tax advisor prior to making your final decision.

IRS Links

IRS - Questions on Foreclosure and Debt Cancellation