Mortgage Cancellation of Debt & Taxes
As a result of the real estate market, people are losing their homes to foreclosure or even a short sale. What many do not realize is that there can be significant tax consequences as a result of either of these transactions. When a property is foreclosed on or sold through a short sale there are two significant tax issues that must be addressed: (1) the taxes associated with potential cancellation of debt income; and (2) the sale or otherwise disposition of the property.
Many people know that there is tax relief under certain circumstances for the cancellation of debt income. However, they often fail to realize that the disposition is also treated as a sale for income tax purposes and a gain or loss must be calculated. Determining the taxable amounts relating to the sale of the property and the cancellation of debt income can be a challenge. It requires financial calculations, a good knowledge of the income tax code and patience and diligence in completing the required income tax forms.
For those who are not aware, the general rule is that cancellation of debt is a taxable event. Some exceptions to this include bankruptcy, qualified farm indebtedness, insolvency, and certain qualified real property business debt. But under the Mortgage Forgiveness Debt Relief Act of 2007 (enacted in 2007), many taxpayers will be able to exclude qualified principal residence indebtedness if the balance of the mortgage was less than $2 million ($1 million for a married person who files separately).
Cancellation of Debt On Rental or Investment Property
Many people have questions regarding the tax impact of the cancellation of debt on rental or investment real estate. During the real estate boom, many people made significant investments in real estate only to wind up losing them through foreclosure or a short sale. There can be significant tax consequences for many of these investors. Dealing with tax issues associated with rental or investment property can be very challenging. Taxpayers need to make sure that they work with a CPA or other qualified tax professional.
Whether or not there is forgiveness of debt income first depends on whether the mortgage debt is recourse or nonrecourse. Debt is recourse if you are personally liable for the indebtedness. Debt is nonrecourse if the property itself is the only collateral for the debt and the lender may not pursue a deficiency against the owner. For nonrecourse debt, since the lender can only take the property back in satisfaction of the debt, there is no occurrence of cancellation of debt. For recourse debt, once the property is sold or foreclosed upon and the lender agrees to forgive the remaining balance of debt, income from cancellation of debt must be addressed.
For a rental property, the tax accounting can get complex. When a rental property is foreclosed or sold through a short sale the owner must address both the cancellation of debt and the gain/ loss on the sale of the property.
If the debt is nonrecourse debt, the amount of the outstanding debt is used as the sales price and the basis is then subtracted. The basis is normally the purchase price less the allowable depreciation (but may include other adjustments). Since the mortgage is nonrecourse there is no cancellation of debt income.
If the debt is recourse debt, the calculation is a little different. Let’s assume that upon foreclosure of the property the bank cancels the remaining debt. You must first calculate the gain or loss on the disposition of the property and then calculate any taxable cancellation of debt income. Since it is recourse debt, the sales price represents the fair value of the property and then you subtract the basis. Since the lender forgave the remaining debt balance (the difference between the outstanding debt balance less the property’s fair value), this amount may be taxable income (unless another exclusion applies).
Cancellation of Debt Income Exclusions
The general rule when it comes to cancellation of debt is that it is a taxable event. But there are some exceptions that you should be aware of. The most common situations when cancellation of debt income is not taxable involve bankruptcy, the Mortgage Forgiveness Debt Relief Act, insolvency, and certain farm and business indebtedness.
Discharges in bankruptcy are generally excluded. If you think this exclusion applies to your situation, make sure to discuss it with your attorney and your CPA. I find that all too often people think this applies to them, but the cancellation of debt either occurred before or after the bankruptcy date.
Another exclusion is available under the Mortgage Forgiveness Debt Relief Act. This Act came into place in 2007 and allows certain exclusions through 2012. The Act applies to qualified indebtedness (normally purchase money and/or original acquisition debt) on a principal residence. Many homeowners will qualify under the Act, but be careful if you did a cash-out refinance or took out a second mortgage. This is where people can often run into trouble.
If the cancellation of debt relates to your primary residence and you don’t qualify under the Act, you may very well qualify under the insolvency exclusion. The insolvency exclusion is very complex and I will dedicate an entire blog post just for this issue. Let’s just say that if you don’t have many assets and you have substantial liabilities you may be able to exclude certain cancellation of debt from income on your tax return.
You can exclude certain farm cancellation of debt from income. Generally, if the debt was incurred 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, your cancellation of debt is generally not considered taxable income.
Cancellation of Debt & Insolvency
If a homeowner is not able to exclude all debt cancellation based on the Mortgage Forgiveness Debt Relief Act, there may be a relief to them if they can prove they were insolvent. You are insolvent when (and to the extent) your liabilities exceed the fair value of your assets. You must determine your liabilities and the fair market value of your assets immediately before the debt cancellation in order to determine if you were insolvent and the amount by which you were insolvent.
For purposes of determining insolvency, your assets would include the value of everything you own (even including any assets that serve as collateral for debt and exempt assets that are beyond the reach of your creditors under law, such as your pension plans and the value of any retirement accounts you may have). Liabilities include the entire amount of any recourse debts and the amount of any nonrecourse debt that is not in excess of the fair market value of the property that is secured by the debt. You can exclude from your gross income debt canceled when you are insolvent, but only up to the amount by which you are insolvent.
Remember that the insolvency calculation is done immediately before the cancellation of debt. This can be tough because in many cases the cancellation of debt occurred many months ago. Just consider how difficult it would be to go back six months to a year in the past and try to determine the balance in your bank account and the value of your retirement account assets. If fact, the most challenging part is determining the value of your household items and personal belongings, such as tools, jewelry, furniture, equipment, and clothing!
An insolvency calculation should only be done with the assistance of a qualified CPA. It is just too difficult for the average person to do on their own.
Cancellation of Indebtedness – Do I Need a CPA?
I see people all the time who are going through a short sale or foreclosure, have a potential income tax problem, and then try to tackle the tax issue themselves. In many cases, it may not result in tax liability, but you should always have a CPA or other tax or legal professional review your transaction and prepare your taxes. The added cost will be money well spent and also give you peace of mind down the road.
If you had a foreclosure or short sale during the year, you will most likely receive a 1099-A or 1099-C at the end of the year. These forms will show the amount of cancellation of indebtedness and the fair value of any property given up. You should review 1099 carefully and make sure to notify the lender immediately if any of the information shown is incorrect or incomplete. You must pay particular attention to the amount of cancellation of indebtedness and the value listed for the real property.
You should review your 1099s with a CPA or other tax or legal professional to determine if the cancellation of indebtedness can be excluded from your taxable income. In some situations, you will need to determine if you were insolvent at the time of the cancellation of debt.
Specifically, a tax professional can help you with the following:
- Analyzing a 1099 for errors and inconsistencies;
- Calculating the gain or loss (if applicable) from the disposition of the property;
- Determining if you meet the cancellation of debt exclusions;
- Calculating insolvency at the debt cancellation date (if applicable); and
- Completing the required tax schedules and forms.
Trust me – the money spent working with a tax professional will be well worth it. This area of income tax law is very complex and the potential tax impact is too large to deal with someone who doesn’t know what they are doing or could treat it incorrectly and give you problems with the IRS!