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Tax Aspects of Foreclosures and ‘Short Sales’

California CPA magazine: January/February 2009

By David M. Fogel, CPA

California experienced a record 800,000-plus foreclosures in 2008, according to RealtyTrack. Since various foreclosure related tax laws have changed, here’s what you need to know.

The Basics
In a foreclosure, the lender exercises its security interest in the property, takes the property and sells it at a foreclosure sale. If the sales price does not meet the indebtedness, the lender may or may not hold the borrower liable for the difference. In a “short sale,” the property is sold to a third party and proceeds go to the lender, which cancels the debt.

A debt is nonrecourse if the lender cannot hold the borrower liable for it and may go only against the value of the property to collect (example: purchase money mortgage where the borrowed funds are used to purchase the home). A debt is recourse if the lender can hold the borrower liable for it beyond the value of the property (examples: second mortgage, refinance loan, line-of-credit loan).

Forms 1099-A or 1099-C are issued by lenders to report the income tax consequences of a foreclosure, short sale, abandonment or deed in lieu of foreclosure. If a lender acquires the property and does not cancel any debt, Form 1099-A is issued. If the lender cancels part or all of the debt, Form 1099-C is issued.

Tax Consequences
If a lender discharges any part of a debt, the taxpayer must recognize that amount as ordinary income [IRC Sec. 61(a)(12)].

When a nonrecourse debt is canceled in exchange for the property, the transfer is treated as a sale [Commissioner v. Tufts, 461 U.S. 300 (1983); Reg. Sec. 1.1001-2(a)(1)]. The amount realized from the sale is the greater of the sales price of the property or the unpaid debt.

Where the debt is recourse, the transaction is split into two parts:

1.)    A taxable disposition of the property; and

2.)    To the extent the fair market value (FMV) of the property is less than the unpaid debt, either a continuing debt obligation is owed to the lender or the remainder of the debt is discharged [Reg. Sec. 1.1001-2(a)(2)].

The gain or loss on the taxable disposition portion is the difference between the property’s FMV and the taxpayer’s adjusted basis. If the lender cancels the remainder of the debt, the borrower will have cancellation of debt income (CODI) equal to the difference between the amount of the debt and the property’s FMV.

If the borrower qualifies, one of the relief provisions available under IRC Sec. 108 may be used to exclude the CODI. A taxpayer who claims this exclusion must file Form 982 with the return.

One such exclusion was added by the Mortgage Forgiveness Debt Relief Act of 2007. IRC Sec. 108(a)(1)(E) allows a taxpayer to exclude up to $2 million ($1 million for married filing separate) of CODI where the debt was secured by the taxpayer’s principal residence. The exclusion is available for discharges of debt that occur during 2007–12.

The exclusion applies only to “acquisition indebtedness,” as defined in IRC Sec. 163(h)(3)(B), which is any indebtedness incurred in acquiring, constructing or substantially improving, and is secured by, the taxpayer’s residence. The exclusion applies to refinancing indebtedness, but only to the extent that it doesn’t exceed the principal balance of the debt paid off by the refinance loan.

To the extent that the refinance loan is used to substantially improve the residence, that portion also qualifies as “acquisition indebtedness” [H. Rept. No. 100-391, Revenue Act of 1987 (P.L. 100-203), 10/19/87].

Gov. Arnold Schwarzenegger signed SB 1055 Sept. 25, partially conforming to the federal law. The bill allows a taxpayer to exclude up to $250,000 of CODI for a maximum debt of $800,000 secured by the taxpayer’s principal residence (these numbers are halved for married filing separate). The relief is available for discharges of debt that occurred during 2007–08.

The following illustrates these rules:
•    December 2005: Residence purchased for $470,000 ($40,000 down, $430,000 nonrecourse loan)

•    February 2007: FMV residence $550,000, loan balance $420,000, refinanced for $500,000 (proceeds used to pay credit cards)

•    December 2007: FMV residence $420,000, loan balance $490,000 (in default), lender forecloses.

•    June 2008: FMV residence $380,000, loan balance $490,000, lender cancels loan.

This results in:
•    2007: Nondeductible $50,000 loss on sale of residence ($420,000 debt relief, $470,000 basis)

•    2008: $110,000 CODI, $30,000 eligible for IRC Sec. 108(a)(1)(E) exclusion.

The refinance loan of $500,000 exceeded the original loan of $420,000, and none of the proceeds were used to improve the residence, so the $80,000 excess doesn’t qualify as “acquisition indebtedness” and is not eligible for the exclusion. 

David M. Fogel, CPA is a Roseville-based tax consultant. You can reach him at dfogel@surewest.net.