Foreclosure Tax Myths
Debunking the tax myths of foreclosures, short sales
California CPA September 2010
By David M. Fogel, CPA
In light of practical problems tax practitioners face in reporting foreclosures and short sales, the following busts the top 10 myths surrounding these transactions.
Myth No. 1: Debt wasn’t canceled because lender issued a Form 1099-A
A lender who acquires property, but does not cancel any debt, is required to issue Form 1099-A (IRC Sec. 6050J). A lender who cancels at least $600 of debt must issue Form 1099-C [Sec. 6050P; Treas. Reg. Sec. 1.6050P-1(a)]. In many foreclosures, lenders have issued Form 1099-A, but not Form 1099-C. That means the lender didn’t cancel any debt.
: In California, lenders can choose between the judicial or nonjudicial foreclosure process.
In a judicial foreclosure, the lender sues the borrower in court. This process is required if the lender wants to obtain a deficiency judgment to hold the borrower liable for the unpaid balance of the debt. In a nonjudicial foreclosure, the lender issues a notice of default to the borrower and, after a waiting period of almost four months, may sell the property at auction (trustee’s sale).
Nearly all foreclosures in California involve the nonjudicial process. Lenders using the nonjudicial foreclosure process are prohibited from seeking a deficiency judgment against the borrower (Sec. 580d of the California Code of Civil Procedure). As a result, the balance of the debt is canceled by operation of law.
Myth No. 2: Nonjudicial foreclosure converted the debt from recourse to nonrecourse.
If the lender used the nonjudicial foreclosure process, the debt was converted from recourse to nonrecourse.
: Several real estate attorneys have told me that this is a misinterpretation of Sec. 580d. This section prohibits a deficiency judgment if the lender used the nonjudicial foreclosure process. It doesn’t convert the borrower’s personal liability for the debt from recourse to nonrecourse.
Myth No. 3: The debt was recourse because Form 1099-C says so.
A client gives you a Form 1099-C that has box 5 checked “Yes,” indicating that the borrower was personally liable for the debt. This means that the debt was recourse.
: In almost all instances I have seen, the “Yes” box on this form has been checked—but you can’t rely on the information on this form without verifying it with your client or from other sources.
Myth No. 4: There is no COD income because the FMV on Form 1099-C exceeds the debt.
A client gives you a Form 1099-C for a canceled recourse loan that shows in box 7 the FMV of the property is more than the principal amount of the debt. Based on this, there was no COD income.
: In many cases, the lender has not ascertained the property’s correct FMV. I have seen two instances where the lender entered the FMV of the property based on an appraisal obtained several years ago for the original loan. Ask your client what the FMV of the property was or determine it from other sources, such as Zillow.com.
Myth No. 5: When the debt was nonrecourse, a short sale results in COD income.
When the property is transferred—if the debt is nonrecourse—then the principal amount of the debt is treated as the “amount realized” in computing gain or loss, and there isn’t any COD income.
Some practitioners have theorized that a short sale is treated as two separate transactions: a loan modification (reduction of the principal amount of the loan) and sale of the property. A loan modification results in COD income whether the loan is nonrecourse or recourse. Therefore, under this theory, the loan modification portion of the short sale results in COD income.
: In a short sale, the lender must approve the terms of the sale and will receive the sales proceeds. Cancellation of the debt and the sale of the property are integrated events that can’t be separated. Even if they could be sepertaed, the step transaction doctrine would combine the events into one transaction.
Myth No. 6: A taxpayer who converted a principal residence to rental use may use the principal residence exclusion for COD income.
If the taxpayer has converted a principal residence to rental use and at the time of the foreclosure or short sale the taxpayer satisfied the requirements for claiming the home sale exclusion, then any COD income resulting from the foreclosure or short sale may be excluded under the principal residence exclusion of Sec. 108.
: At the time that the debt was canceled, it was no longer “qualified principal residence indebtedness” and therefore not eligible for this exclusion. Instead, the COD income might be excludable under the Qualified Real Property Business Indebtedness (QRPBI) exclusion (see “Taxing Times on Properties,” October 2009 California CPA).
For a taxpayer’s principal residence, COD income is excluded if “the indebtedness discharged is qualified principal residence indebtedness which is discharged before Jan. 1, 2013” [Sec. 108(a)(1)(E)]. “Qualified principal residence indebtedness” means acquisition indebtedness under Sec. 163(h)(3)(B) with respect to the principal residence of the taxpayer [Sec. 108(h)(2)].
However, when a principal residence is converted to rental use, the debt no longer qualifies as acquisition indebtedness under Sec. 163(h)(3)(B). Under IRS regulations, a change in use of the property requires the debt to be reallocated to reflect the new use [Treas. Reg. Sec. 1.163-8T(j)(1)(i)(B)].
Myth No. 7: To calculate gain or loss, a taxpayer using the principal residence exclusion must reduce the basis of the residence.
If a taxpayer’s principal residence has been lost to foreclosure or a short sale resulting in COD income, and if the COD income is excludable under the principal residence exclusion, then the taxpayer must reduce the basis of that residence in calculating gain or loss.
: When a taxpayer excludes COD income under the principal residence exclusion, the law requires the taxpayer to reduce (but not to an amount below zero) the basis of the residence [Sec. 108(h)(1)]. But in a foreclosure or short sale, the balance of the debt is canceled when the taxpayer no longer owns the residence. As a result, there is no basis to be reduced [Pub. 4681, p. 15].
Myth No. 8: The taxpayer must reduce the basis of rental property by the insolvency exclusion.
If a taxpayer uses the insolvency exclusion to exclude COD income resulting from a foreclosure or short sale of rental property, then the adjusted basis of the rental property must be reduced by the exclusion in order to calculate gain or loss.
: The adjusted basis is reduced only if the taxpayer uses the QRPBI exclusion. A taxpayer who was solvent immediately before the foreclosure or short sale and uses the QRPBI exclusion must reduce the basis of the rental property by the QRPBI exclusion [Sec. 1017(b)(3)(F)(iii)].
However, a taxpayer who was insolvent immediately before the debt was canceled is required to use the insolvency exclusion instead of the QRPBI exclusion [Sec. 108(a)(2)(B)]. Under the insolvency exclusion, the taxpayer’s “tax attributes” (net operating loss carryovers, certain tax credits, capital loss carryovers, basis of property, passive loss carryovers and foreign tax credit carryovers) must be reduced in this order, and the reductions are made at the beginning of the next tax year [Secs. 108(b)(2) and (4)].
Myth No. 9: The taxpayer may not claim a net operating loss for rental property foreclosure.
Many taxpayers who lost rental properties to foreclosure or short sale have excluded the COD income using the insolvency exclusion. In such cases, the foreclosure or short sale usually resulted in an ordinary loss under Sec. 1231 that may have caused a net operating loss (NOL). This NOL is one of the “tax attributes” that must be reduced before carrying it to another tax year.
: According to Treas. Reg. Sec. 1.108-7(b), the NOL may be carried back to preceding tax years before the taxpayer is required to reduce it.
Myth No. 10: Adjusted basis of personal residence converted to rental property is its original cost.
In calculating the gain or loss on the foreclosure or short sale of a taxpayer’s personal residence that was converted to rental property, the taxpayer’s adjusted basis is its original cost, minus depreciation and the QRPBI exclusion.
When property has been converted from personal use to business use, the adjusted basis for calculating loss is the lesser of the original cost or FMV of the property at the time it was converted to rental use, minus depreciation and the QRPBI exclusion [Treas. Reg. Sec. 1.165-9(b)(2)]. The adjusted basis for calculating gain is the original cost of the property, minus depreciation and the QRPBI exclusion [Treas. Reg. Sec. 1.1012-1(a)].
David M. Fogel, CPA
is a Roseville-based tax consultant.