I speak to folks every day who are losing their homes by foreclosure or are going through a short sale. I have posted here my top 10 questions that I am asked regarding the tax impact of the transactions (including debt cancellation).
What is a cancellation of debt?
If you borrow money to buy a home and the lender subsequently cancels some (or all) of the debt, you may have to include the canceled amount in income on your income tax return. When you borrowed the funds you did not include the proceeds in income because you were obligated to repay the bank at the time. When the obligation is subsequently relieved and the debt was recourse debt, the amount is reported as income because you no longer have an obligation to repay the lender. The lender is usually required to report the amount of the cancellation of debt to you and the IRS on Form 1099-C, Cancellation of Debt.
Is Cancellation of debt always taxable?
No…not always. There are some exceptions to consider. The most common situations when cancellation of debt income is not taxable to you involve:
- Bankruptcy – Debts discharged through bankruptcy are usually not considered taxable income.
- Mortgage Forgiveness Debt Relief Act – Cancellation of debt that qualifies under the Act is not considered taxable.
- Insolvency – If you were insolvent when the indebtedness was forgiven, some or all of the forgiven debt may not be taxable income.
- Certain farm debts – If you incurred the indebtedness directly in the operation of a farm, more than half your income from the prior three years was from farming, and the loan was owed to a person or agency regularly engaged in lending activities, the relieving debt is generally not considered taxable income.
What is the Mortgage Forgiveness Debt Relief Act of 2007?
The Act generally allows taxpayers to exclude cancellation of debt income resulting from their principal residence as long as it is qualified principal residence indebtedness (as defined). Debt reduced through a mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure qualifies for this relief. The Act applies to debt that is canceled during calendar years 2007 through 2012.
I lost money on the foreclosure or short sale of my principal residence. Can I claim this loss on my tax return?
No…unfortunately any losses from the sale or foreclosure of personal property are not deductible.
I have heard about the Insolvency exclusion…what is that?
You are not required to include cancellation of debt in income to the extent that you were insolvent immediately before the cancellation. You were insolvent immediately before the cancellation to the extent that the total of your liabilities exceeded the fair value of your assets immediately before the cancellation.
I just lost my home through foreclosure or a short sale. Are there any tax consequences?
There are two possible consequences you must consider:
- Taxable cancellation of debt income. (note: cancellation of debt income is not taxable in the case of non-recourse loans.)
- A reportable gain or loss resulting from the sale of the home (because foreclosures are treated like sales for income tax purposes).
What about rental properties, vacation homes, and other investment real estate?
Debt that is canceled on a rental property, a second home, or other investment real estate does not qualify under the Mortgage Forgiveness Debt Relief Act. For rental properties, the taxpayer may be able to recognize a loss on the real property but also must consider recapturing any allowable depreciation. Dealing with tax issues associated with rental or investment property can be a challenge. Taxpayers need to make sure that they use a CPA or other qualified tax professional to review their situation.
I don’t agree with the information on my Form 1099-C. What should I do?
You must contact the lender (or bank) immediately. The lender should issue a corrected 1099-C if the information is determined to be incorrect or incomplete. Retain all records related to the purchase and sale of your home and all related debt refinancings.
Can you give me an example?
Assume that a homeowner buys a principal residence for $325,000 with a down payment of $25,000 and secures a recourse mortgage of $300,000. Now assume that the property appreciated to $450,000 and the taxpayer took out a second mortgage for $100,000 (total debt now of $400,000). The money on the second was used to pay off credit cards, buy a new car and take a vacation.
Let’s assume that the home is now sold through a short sale for $250,000 and the entire balance of the second mortgage is canceled ($100,000) along with $50,000 of the first mortgage. Assuming the debt was not discharged in bankruptcy, the taxpayer would have $50,000 of cancellation of debt income that should meet the exclusion under the Mortgage Forgiveness Debt Relief Act. The $100,000 of nonqualified debt from the second mortgage would be taxable unless the taxpayer qualified, in whole or in part, for the insolvency exclusion.
Can I do my tax return myself?
You certainly can but I advise you against it. There is just a lot of margin for error and you could cause problems for yourself. Seek the counsel of a qualified CPA or other tax professional.