One of the harsh realities of our beloved taxing system is that it will tax you on any benefit received. With the housing market still crawling out from the depths of its collapse, many taxpayers are still saddled with mortgages so disproportionate to the value of the underlying real property that simply walking away from the debt seems the only option. What are the consequences associated with foreclosure/short sale/debt forgiveness, and why are you lucky if you live in California?
In general, if you owe a debt to someone else and they cancel or forgive that debt, the canceled amount is income subject to tax. This comes up most often in the context of home mortgages and other loans secured by real property. If a mortgagor forecloses/agrees to a short sale/ or somehow modifies the debt, any deficiency or amount of the debt forgiven could be income. Assume a loan for $500,000.00 secured by real property. Assume further that the owner simply walks away from the property and the lender forecloses realizing only $300,000.00 on the foreclosure sale. Assuming no deficiency judgment, in many instances, the lender will actually send the borrower a 1099 indicating $200,000.00 of ordinary income. Not a great result.
What to look for in California:
- Is my home loan recourse or non-recourse. Non-recourse loans do not result in Cancellation of Debt (COD) income, the policy being that since the lender never had recourse beyond the underlying real property securing the loan, foreclosure on that underlying real property fully satisfies the loan resulting in no COD income.
- One lucky aspect of living in California is that it is a non-recourse state. Basically, this means that most loans procured in anticipation of purchasing a residence are non-recourse meaning that foreclosure on these loans will usually not result in COD income to the borrower. (There are multiple nuances to this, not the least of which is the fact that refinancing usually converts a non-recourse loan to a recourse loan in California. A borrower should have his or her loan document thoroughly reviewed by counsel prior to making any final determinations on whether to walk away from a loan and simply allow foreclosure.)
- Is the loan on my personal residence as that term is defined under the Internal Revenue Code? If a foreclosure/short sale or loan modification does ultimately lead to COD income, there may be some exemptions allowing the borrower to avoid paying income tax.
The Mortgage Debt Relief Act of 2007 generally allows taxpayers to exclude income from the discharge of debt on their principal residence. Both debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief.
Under the new law, a discharge of "qualified principal residence indebtedness" is excluded from taxable income. "Qualified principal residence indebtedness" is acquisition indebtedness secured by the principal residence of a taxpayer as defined for the deduction of residential mortgage interest, but the limit is $2,000,000 for the exclusion ($1,000,000 for the mortgage interest deduction) and $1,000,000 for married persons filing a separate return ($500,000 for the mortgage interest deduction). Also, the exclusion only applies to a mortgage secured by the principal residence of the taxpayer.
If, however, the taxpayer continues to own the home after the debt cancellation, generally occurring upon a loan modification agreement, the tax basis of the residence (cost used to determine taxable gain or loss upon a subsequent sale) is reduced by any amount of discharge of indebtedness excluded from taxable income, but not below zero.
As you can see, the Federal Government is at least trying to alleviate some of the destructive force of the housing bubble burst. Although these exemptions/exclusions, loan nuances are well known, understanding how they apply to any borrower’s specific situation can and is tricky. If you have any questions regarding your loan, or any inquiries in general, please do not hesitate to contact us.
