The following two posts are excerpts of a fantastic article written by Michael C. Gray, CPA, an expert in real estate tax issues. It is so good that I felt compelled to share it with you in detail. It outlines very well the tax ramifications of short sales and foreclosures. The next post will review the Mortgage Debt Relief Act signed into law by President Bush. This is such a key element with respect to the housing crisis and the personal challenges each of us faces. I have personally spoken to so many individuals who are confused as to what to do and have no idea about this law protecting them for this income tax.
Our nation is now seeing the effects of tightening mortgage credit after a liberal period. With increases in interest rates for adjustable rate mortgages and the conversion to amortization of principal for interest-only (or negative amortization) loans, home values for homes favored by sub-prime borrowers are collapsing, and the debtors are either trying to “walk away” from their homes and allowing them to be foreclosed or are making “short sales”.
A “short sale” is selling the home for less than the mortgage balance and trying to get the lender to forgive the unpaid balance. This is a new use of the term, and is not the definition for this item in the Internal Revenue Code. In the tax law, a “short sale” is a sale of a borrowed item to be replaced at a future date, usually a security. The only case that I know about using the term “short sale” for this type of transaction is a 2008 decision, Stevens v. Commissioner.1 With the explosion of real estate short sales, we will undoubtedly soon see more cases with them.
A reason for debtors to consider a “short sale” instead of a foreclosure is to try to protect their credit history.
How are foreclosures (and deeds in lieu of foreclosure) taxed?
An important consideration in the results of a foreclosure (or a deed in lieu of foreclosure) is whether the debt is “recourse” or “non-recourse”. If the debt is “recourse”, the debtor is personally liable for the debt. If the debt is “non-recourse”, the debt is only secured by the property, and the debtor is not personally liable for the balance.
You should consult with an attorney to determine the status of your mortgage. In California, most mortgages that are used to purchase a residence are non-recourse, but mortgages from refinancing a previous mortgage are usually recourse.
When a non-recourse mortgage is foreclosed, the property is treated as being sold for the balance of the mortgage.2 (G. Hammel, SCt, 41-1 USTC ¶ 9169.) This is important because the gain from a foreclosure of a principal residence may be eligible for the $250,000 ($500,000 for jointly-owned marital property) exclusion.
For example, for foreclosure of a non-recourse debt,
| Non-recourse debt | $500,000 |
| Tax basis (cost to determine tax gain or loss) | 300,000 |
| Gain | $200,000 |
If the holding period requirements are met and the residence was a principal residence, the above gain would be tax-free.
(Note: The above example is for consistency and contrast with the results for recourse debt. Most non-recourse debt for a residence is purchase-money debt, and would not exceed the tax basis (purchase price) of the residence. When the residence was a replacement residence for a principal residence sold before May 7, 1997, the tax basis can be less than the cost of the residence. Most of the mortgages for residences acquired in that scenario have probably been refinanced and are now recourse debt.)
For recourse debt, the debt is only satisfied up to the fair market value of the property. There is a sale up to that amount. If the lender forgives the balance of the mortgage, there is cancellation of debt income, which is taxed as ordinary income.3 (Regulations § 1.61-12.) (But see tax relief enacted for certain recourse debt secured by a principal residence, below.)
For example, for foreclosure of a recourse debt,
| Recourse debt | $500,000 |
| Fair market value | 450,000 |
| Cancellation of debt (ordinary income) | $ 50,000 |
(If the cancellation of debt was for “qualified principal residence indebtedness”, it will be excluded from taxable income. If the taxpayer still owns the home after the cancellation of debt, the excluded amount will be subtracted from the tax basis of the residence. See the section on “tax relief”, below.)
| Fair market value | $450,000 |
| Tax basis | 300,000 |
| Gain | $150,000 |
Again, if the holding period requirements are met and the residence was a principal residence the above gain would be tax-free, but the cancellation of debt would generally be taxable as ordinary income, except for certain “qualified principal residence indebtedness.” See the section on “tax relief”…
We will cover that Empowering information in our next post…stay tuned!
