Foreclosure and the IRS

In a recent issue of Niche Report I wrote an article on how to safely “walk away” from your mortgage. That article discussed consumer protection statutes enacted by such states as California known to lawyers and  real estate professionals alike as “anti – deficiency” legislation. This legislation protects homeowners who could no longer afford to debt service their mortgage from personal liability on their mortgage and allows them to simply “walk away” from an over encumbered or “underwater” property.

That article sparked a number of inquiries from our readers many of whom wondered what the impact of the Internal Revenue rules on cancellation of debt had on those homeowners who elected to “walk away” from their mortgage, lost their home through foreclosure or benefited from a short – sale or modification that included a principal reduction. This article attempts to shed some light on that subject.

Generally, if a debt for which you are personally liable is canceled or forgiven, other than as a gift or bequest, you must include the canceled amount in your income.  

In the context of today’s real estate market, this means that when your property is foreclosed upon or repossessed and sold, you are treated for purposes of income tax as having sold the property at the fair  market value.  Whether you ultimately have a recognizable gain for tax purposes depends upon whether you are personally liable for the debt and whether the outstanding loan balance is greater than the fair market value of the property. 

 

When a foreclosure takes place, whether by a strategic “walk away” default or otherwise, it is common for the underlying debt securing the home to be far greater than the current fair market value of the property being foreclosed upon. Why else would someone “walk away” and allow their property to be foreclosed, but for the fact that there is no equity?

Should you lose your home by foreclosure, cancellation of debt occurs.  However, foreclosure is not the only situation in which cancellation of debt occurs. Homeowners who were able to secure a short sale, deed in lieu or for those lucky enough to have negotiated a principal reduction modification are all subject to the Internal Revenue rules on cancellation of debt. 

Given that foreclosure, short sales and modifications are pervasive in this economy the subject of cancellation of debt is something that all homeowners must consider when deciding on how to deal with their over encumbered property. 

While the general rule is that tax payers who receive the benefit of a cancellation of indebtedness are subject to taxation for a recognizable taxable gain, fortunately there are several exclusions and exceptions which may result in part or all of the forgiven debt not being nontaxable.  

The first and most often used exclusion is the “Bankruptcy” exclusion. Under this exclusion a debt cancelled as a result of filing for bankruptcy under Title 11 of the United States code would be excluded and non - taxable.

The second most common exclusion is the “Insolvency” exclusion. This provision of the IRS code provides that if the total of all your liabilities was greater than the fair market value of your assets at the time the debt was cancelled, there is no recognizable gain from the cancellation for tax purposes.

By far, however, the most important exclusion can be found in the Mortgage Debt Relief Act of 2007.   Enacted by Congress as a direct result of the crash in Wall Street, our economy and the real estate market this legislation was specifically designed to protect those homeowners who are burdened by a mortgage they can no longer afford and a principal residence they are unable to sell.

This Mortgage Debt Relief Act of 2007 generally allows taxpayers to exclude income from the discharge of debt on their principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for this relief.

The provisions of this Congressional enactment apply to debt forgiven in calendar years 2007 through 2012. Up to $2 million of forgiven debt is eligible for this exclusion ($1 million if married filing separately). To qualify, the debt must have been used to buy, build or substantially improve your principal residence and be secured by that residence.

Refinanced debt proceeds used for the purpose of substantially improving your principal residence also qualify for the exclusion. 

One must be careful, however, proceeds of refinanced debt used for other purposes – for example, to pay off credit card debt – do not qualify for the exclusion.  In addition, debt forgiven on second homes or rental property does not qualify for this tax relief provision. In some cases, however, other tax relief provisions – such as insolvency or bankruptcy – may be applicable.

More information on this subject including detailed examples can be gotten from your tax professional or found in IRS Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments. Also see IRS news release IR-2008-17.