When mortgages are not paid in full upon the transfer of real estate, as in the case of foreclosures and short sales, there likely will be tax consequences that need to be addressed. What follows are some general guidelines to make you aware of the issues and consequences of such transfers. I strongly recommend that you get professional help with your taxes in any year where you have a short sale or foreclosure. You could end up paying a lot more in taxes (as well as penalties and interest if you do it wrong) than the fees incurred for professional preparation!
Here is an overview of the topic from the IRS website:
I need to get some definitions out of the way first.
A regular or normal sale of real estate is when the buyer pays enough for the property to cover the mortgage and other expenses of sale.
A short sale is when the buyer’s payment is insufficient to cover the mortgage and other expenses of sale. In this situation, the mortgage holder typically agrees to accept a payment through the sale that is LESS than the current balance on the mortgage.
A foreclosure is when the mortgage holder takes back the property – either through legal action, or by the debtor giving the lender a deed in lieu of foreclosure. In a foreclosure, there typically is a balance that remains unpaid on the mortgage.
When considering the tax consequences of a short sale or foreclosure (including deed in lieu of foreclosure), you must think of this process as two separate transactions. The first part is the SALE of the property. The second transaction MAY be a forgiveness of debt (assuming the lender does not go after the debtor for the balance owed on a note)
A couple of more definitions are needed here. The first term is a NON-RECOURSE. In this situation, the lender can ONLY look to the property that secures the loan for payment if the debtor does not fully pay the note. In other words, if the lender takes back a home worth, say, $150,000 – but has a mortgage that is $250,000, the lender must “write off” the $100,000 difference between what was owed on the mortgage and what they received. In a non-recourse note, the lender cannot go after the debtor for the difference.
This is the scenario with PURCHASE MONEY mortgages in California and in many other states. To illustrate, if you buy a house with a down payment and a loan from a lender, so long as you do not REFINANCE that loan, it is considered a purchase money mortgage. However – and here is the problem most homeowners here in CA face – if you refinanced the loan to (1) get a lower interest rate, or t(2) take out some of the equity that resulted from increased property values, the purchase money mortgage is paid off. Accordingly, the NEW mortgage no longer qualifies as a PURCHASE MONEY MORTGAGE. The loan secured by your property is now a RECOURSE mortgage.
That brings us to the second term – RECOURSE. In this circumstance, the lender can look beyond their secured interest in the real estate to collect the difference between what they ultimately get (or give credit for) on the property they acquire in a foreclosure, and the unpaid portion of the note. If the lender gets a deficiency judgment, they can attach salaries, personal property or other real property as part of the collection process.
One other term to discuss is ADJUSTED BASIS. For most taxpayers, this is what they paid for the property. That figure is INCREASED if the homeowner improved the property (added a new bedroom, adding a pool or new roof, etc). That figure is DECREASED if there was a casualty (fire, earthquake, etc) for which the taxpayer claimed a casualty loss deduction on their tax return.
When a home is transferred, the capital gain, if any, is the extent by which the SALES PRICE exceeds the ADJUSTED BASIS. In a normal sale, the sales price is reflected on the escrow settlement sheet (what the seller and buyer agreed to be the price for the property). Selling expenses (like your broker’s commission, title fees, etc) are added to the basis in the computation of your gain or loss.
It is not as easy to determine the SALES PRICE when there is forgiveness of the loan balance. The actual sales price will depend on whether the loan was RECOURSE or NON RECOURSE, and in some situations, the actual Fair Market Value (FMV) of the property at the time of its transfer. When there is a non-traditional sale (short sale or foreclosure), the lender will issue either a 1099-A (Acquisition or Abandonment of Secured Property – in which the lender states whether the loan is recourse or non-recourse), or a 1099-C (Cancellation of Debt). In the latter form, there is no indication of the type of loan. A lender may issue both forms if the transaction spans into two tax years.
Let’s look at the sales price in more detail.
If the underlying debt is RECOURSE, the sales price (for determining capital gain) will be the amount stated as gross proceeds in the escrow documents. If the underlying debt is NON-RECOURSE, the sales price is the balance of the loan.
If the underlying debt is NON-RECOURSE, the sales price is the FULL AMOUNT of the loan regardless of the current FMV of the property.
If the underlying debt is RECOURSE, then the sales price (again – for determining any gain on sale) is the LESSER of:
(a) the outstanding debt IMMEDIATELY before the transfer REDUCED by the amount the debtor remains personally liable for, or
(b) the FMV of the transferred property.
The FMV is usually the “gross foreclosure bid price.” This should be the current value of the property – and in fact, it is important to actually have an appraisal of the property since the value can be critically important in the tax computation.
If the debt is NON-RECOURSE, there no cancelation of debt income to be reported.
If the debt is RECOURSE, then there CAN be reportable income if (1) the loan is GREATER than the FMV of the property, and (2) the bank forgives the debtor for this difference. If the debt forgiven includes the ACCRUED INTEREST in the loan, then the ACCRUED INTEREST (assuming the cancellation of debt is taxable) can be taken as an itemized deduction on Schedule A. Any administrative costs incurred by the lender and added to the cancelled debt can be added to the adjusted basis of the property.
Once you know the sales price, then the capital gain or loss on the sale/foreclosure can be computed. It this was a personal residence and qualifies for the exclusion of the gain (under Internal Revenue Code Section 121), then the exclusion can apply (up to $250,000 for single filing status, $500,000 for married filing joint status). The availability for use of the exclusion has a number of scenarios – so seek professional guidance in this area.
After computing the gain or loss on the sale of the property, then it is time to look at whether any income must be reported as a result of the cancellation of the debt. The cancellation of debt becomes ORDINARY INCOME unless the taxpayer will qualify for an exemption under the Internal Revenue Code section 108. The exceptions include bankruptcy, insolvency (immediately before the transfer), qualified farm indebtedness, qualified real property business indebtedness, and qualified principal property indebtedness.
It would be wise to consult with a tax professional regarding your qualification for one of the exceptions should you be faced with the potential cancellation of debt income (especially if you have received a 1099-C). They are beyond the intent of this primer on foreclosures/short sales.
The IRS has a publication that has examples and further explains this process. – Publication 4681. It is available on the IRS website (www.irs.gov).
Again – if you experienced a foreclosure or short-sale during the tax year, I do recommend that you seek professional help. Remember – in the event you do have potential income from cancellation of debt, there may be a way to reduce or eliminate it by application of Section 108 of the Internal Revenue Code.