SPECIAL REPORT:
Foreclosures & Short Sales -
What Are The Tax Consequences?

www.SundinCPA.com
paul@sundincpa.com

IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein. Disclaimer: The contents herein are used for informational purposes only and may not be suitable for your situation. This report is meant to present general concepts relating to the taxation of cancellation of debt and foreclosures and is not intended to address any specific circumstances. Each situation is unique and taxpayers should discuss their specific debt cancellation or foreclosure transaction with a tax professional.

Background

Based on the current real estate market and the overall economic climate, many homeowners find themselves losing their homes either through foreclosure or a short sale. There can be significant tax consequences for both of these transactions. What many people fail to realize is that when a property is foreclosed on or sold through a short sale there are two tax issues that must be addressed: (1) the cancellation of indebtedness; and (2) the sale or disposition of the property.

Many homeowners are aware that relief exists under certain circumstances for cancelled mortgage indebtedness. However, many people do not realize that the transactions are also treated as sales for tax purposes and a gain or loss must be calculated. Determining any taxable amounts for the sale of the property and the debt cancellation can be difficult. It requires strict financial calculations, knowledge of the tax code and diligence in completing the required tax forms.

Debt Foregiveness

Generally, debt forgiveness results in taxable income. Some exceptions include Title 11 bankruptcy, insolvency, qualified farm indebtedness, and certain qualified real property business indebtedness. However, under the Mortgage Forgiveness Debt Relief Act of 2007 (enacted on Dec. 20, 2007), taxpayers may now exclude qualified principal residence indebtedness if the balance of their loan was less than $2 million ($1 million for a married person filing a separate return). This exclusion applies to debt discharges made after 2006 and before 2010.

It is important to note that there are exceptions to debt forgiveness under the Act. Debt reduced through a short sale, mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure may qualify for this relief. Debt forgiven on second homes, rental property, business property, credit cards or car loans does not qualify for the new tax-relief provision. In some cases, however, other kinds of tax relief may be available.

Your principal residence is defined as the home where you ordinarily live most of the time. You can have only one principal residence at any one time. Qualified principal residence indebtedness is a mortgage you took out to buy, build, or substantially improve your principal residence. It must be secured by your principal residence. You cannot exclude from gross income the discharge of qualified principal residence indebtedness if the discharge was for services performed for the lender or as a result of any other factor not directly related to a decline in the value of your residence or to your financial condition.

If the amount of your original mortgage is more than the cost of your principal residence plus the cost of any substantial improvements, only the debt that is not more than the cost of your principal residence plus improvements is qualified principal residence indebtedness. Any debt secured by your principal residence that you use to refinance qualified principal residence indebtedness is treated as qualified principal residence indebtedness, but only up to the amount of the old mortgage principal just before the refinancing. Any additional debt you incurred to substantially improve your principal residence is also treated as qualified principal residence indebtedness.

If only a part of a loan is qualified principal residence indebtedness, the exclusion applies only to the extent the amount discharged exceeds the amount of the loan (immediately before the discharge) that is not qualified principal residence indebtedness. For example, assume your principal residence is secured by a debt of $300,000, of which $225,000 is qualified principal residence indebtedness. If your residence is sold for $200,000 and $100,000 of debt is discharged, only $25,000 of the debt discharged may be excluded (the $100,000 that was discharged minus the $75,000 of nonqualified debt). The remaining $75,000 of nonqualified debt may qualify in whole or in part for one of the other exclusions, such as the insolvency exclusion.

Sale or Disposition of Property

As discussed previously, when a property is foreclosed on or sold on a short sale there are two tax issues that must be addressed: (1) the cancellation of debt; and (2) the sale or disposition of the property. The calculation of the gain or loss on the disposition of the home is important, especially for owners of rental properties. For principal residences, often some or all of the gain from the sale of a personal residence qualifies for exclusion from income. If you have owned and used the home as your principal residence for periods totaling at least two years during the five year period ending on the date of the foreclosure, you may exclude up to $250,000 (up to $500,000 for married couples filing a joint return) from income.

To calculate any gain or loss you must first determine the fair market value of the property foreclosed (or for non-recourse loans, the amount of the debt immediately prior to the foreclosure) and then subtract your adjusted basis in the property (usually your purchase price plus the cost of any major improvements). The basis of the principal residence must be reduced (but not below zero) by the amount excluded from gross income. This amount is your gain or, if negative, your loss on the sale of the property. If you do not qualify for the principal residence exclusion, or your gain exceeds $250,000 ($500,000 for married couples filing a joint return), you must report the taxable amount. Losses from the sale or foreclosure of personal property are not deductible.

Insolvency

If a homeowner is not able to exclude all debt cancellation based on the Mortgage Forgiveness Debt Relief Act, there may be relief if the homeowner can prove they were insolvent at the time of the transaction. You are insolvent when, and to the extent, your liabilities exceed the fair market value of your assets. Determine your liabilities and the fair market value of your assets immediately before the cancellation of your debt to determine whether or not you are insolvent and the amount by which you are insolvent.

For purposes of determining insolvency, assets include the value of everything you own (including assets that serve as collateral for debt and exempt assets which are beyond the reach of your creditors under the law, such as your interest in a pension plan and the value of retirement accounts). Liabilities include the entire amount of recourse debts and the amount of nonrecourse debt that is not in excess of the FMV of the property that is security for the debt. Exclude from your gross income debt canceled when you are insolvent, but only up to the amount by which you are insolvent.

If a debtor excludes canceled debt from income because it is canceled in a bankruptcy case or during insolvency, he or she must use the excluded amount to reduce certain ''tax attributes.'' Tax attributes include the basis of certain assets and certain losses and credits. By reducing these tax attributes, tax on the canceled debt is in part postponed instead of being entirely forgiven. This prevents an excessive tax benefit from the debt cancellation.

What Does This Mean To Me?

If you had a foreclosure or short sale during the year, you will probably receive a yearend statement on Form 1099-A or 1099-C as a result of the transaction. The lender is required to provide this form to you by January 31st of the following year. By law, this form must show the amount of debt forgiven and the fair market value of any property given up through foreclosure. Make sure to review any 1099 carefully and notify the lender immediately if any of the information shown is incorrect. You should pay particular attention to the amount of debt forgiven (Box 2) and the value listed for their home (Box 7).

You should review your 1099s with a tax professional to determine if any of the debt cancellation can be excluded from taxable income. In many situations, you may need to determine whether you were insolvent at the time of the debt cancellation.

How We Can Help

As a CPA firm, we can assist with you with determining the proper tax treatment for your situation. Specifically, we can assist you with:

• Reviewing your 1099s for errors or inconsistencies;
• Calculating gain or loss from the sale or disposition of the property;
• Determining whether you meet the debt cancellation exclusions;
• Calculating insolvency at the debt cancellation date (if applicable); and
• Completing the required tax forms and schedules.

We offer clients a FREE consultation regarding their short sale or foreclosure transaction. Please contact Paul B. Sundin, CPA for a free discussion at 480-626-8043 or email him at paul@sundincpa.com.