Tax Consequences - Foreclosure and Short Sale

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.

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 foregiveness 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

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.

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.

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.

(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.

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.

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

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 This e-mail address is being protected from spambots. You need JavaScript enabled to view it .  Visit www.Sundincpa.com for more information.