Short Sale or Foreclosure of a Principal Residence

It would be a bad dream for any homeowner: selling a home when the debt that secures the property is greater than its fair market value (FMV). With the real estate market slowing, more homeowners are discovering that this can actually happen.

When the real estate market was booming, homeowners either borrowed heavily to buy in at the top or took out home-equity loans, which added to their debt. Now that the real estate market has cooled, some homeowners are finding that their debt exceeds the FMV of the property. Not only do they owe money to the bank and are forced to sell, but there could be some unexpected income tax consequences as well. 

This item discusses the tax implications of short sales and foreclosures, both of which may be only a missed mortgage payment or two away, and are often the only solutions to an otherwise uncertain situation.

Definitions

Short sale: Through a bank workout program called a short sale, lenders approve a house sale if a homeowner is behind on payments and owes more than the property’s FMV. The lender takes a discount by allowing the homeowner to sell the home at less than the mortgage debt. Short-sale contracts help lenders unload unwanted property and avoid many expenses associated with the foreclosure process. The bank will lose a little now to avoid losing more in foreclosure.

Deed in lieu of foreclosure: This is a deed instrument in which a mortgagor (the borrower) conveys all interest in real property to the mortgagee (the lender) to satisfy a loan that is in default and avoid foreclosure. It offers several advantages to both the borrower and the lender. The principal advantage to the borrower is that it immediately releases him or her from most or all of the personal indebtedness associated with the defaulted loan. The borrower also avoids the public notoriety of a foreclosure proceeding and may receive more generous terms than in a formal foreclosure. Advantages to a lender include a reduction in the time and cost of repossession and additional advantages if the borrower subsequently files for bankruptcy.

Foreclosure: This is the legal process reserved by the lender to terminate the borrower’s interest in a property after a loan has been defaulted. The lender sets a minimum price that it is willing to accept for a property to be sold at auction. When the process is completed, the lender may sell the property and keep the proceeds to satisfy its mortgage and any legal costs. Any excess proceeds may be used to satisfy other liens or be returned to the borrower.

Lenders do not want to own real estate and will go to great lengths not to foreclose. It is a process that costs them time and money and leaves them owning the property. Foreclosing on a property creates a nonperforming asset on the lenders’ books. 

DOI Income

Either a short sale or foreclosure (or deed in lieu of foreclosure) can result in discharge of indebtedness (DOI) income to the debtor if the lender forgives some or all of the unpaid debt.  In general, cancellation or forgiveness of a debt results in gross income for the debtor, unless an exception applies because the taxpayer is bankrupt or insolvent (Secs. 61(a)(12) and 108(a)).

Example 1: J purchased his home in 2004 for $450,000, financing it with a balloon payment mortgage loan from a local bank. In 2006, his employer transferred him to another state and he was forced to sell his home, the value of which had dropped to $400,000. J found a buyer for this amount and then renegotiated the principal balance of his mortgage from $450,000 to $400,000. He used the $400,000 to pay off the loan and walked away from the deal with no out-of-pocket loss.

Because J was solvent when the loan was renegotiated, the full amount of the loan reduction ($50,000) is taxable DOI income. Because it was a nonbusiness bad debt, the DOI income is reported as “other income” on line 21 of Form 1040. J also has a $50,000 ($400,000–$450,000) tax loss on the sale of his home. For homes used solely as personal residences, losses are not deductible.

Foreclosure by Lender: Recourse Debt

A short sale, foreclosure, or deed- in-lieu-of-foreclosure transaction may result in DOI income to the borrower when recourse debt is involved. The lender’s taking of the property in satisfaction of the recourse debt is treated as a deemed sale with proceeds equal to the lesser of FMV at the time of foreclosure or the amount of secured debt. If the amount of debt exceeds the FMV, the difference is treated as DOI income if it is forgiven (Regs. Sec. 1.1001-2(c), Example (8); Rev. Rul. 90-16). The bid price in a foreclosure sale is presumed to be the property’s FMV unless there is clear and convincing proof to the contrary (Regs. Sec. 1.166-6(b)(2)). 

DOI income occurs in a foreclosure transaction only if the lender discharges part or all of any deficiency on taking the property securing it. If the lender fails to pursue the creditor or to discharge all of the indebtedness, DOI income results when the status (under state law) for enforcing the debt expires.

When certain lenders (e.g., banks, savings and loans, and other financial institutions) foreclose on property or take property in lieu of foreclosure, they must issue a Form 1099-A, Acquisition or Abandonment of Secured Property, to the borrower. This form provides information such as the foreclosure date, the outstanding loan principal balance, and whether the borrower is personally liable for repayment of the remaining balance. State law controls when a debtor is deemed to be relieved of a liability. The mere issuance of a Form 1099-A is not controlling if state law provides that the discharge occurs in a different tax year. Some lenders required to file Form 1099-A must also issue Form 1099-C, Cancellation of Debt, for debt discharges. However, it is not necessary to file both Forms 1099-A and 1099-C for the same debtor. Instead, only Form 1099-C needs to be filed.

Example 2—foreclosure on personal residence with recourse debt: M and S purchased their home in 2001 for $300,000. They put down $15,000 and obtained a 30-year recourse mortgage from lender A. In subsequent years, the real estate market was red hot, resulting in M and S’s home being appraised at $450,000 in December 2004. The couple decided to borrow an additional $100,000 (home-equity line, interest-only payments) against their home from lender B for a home improvement project. From 2001 until early 2006, M and S made their mortgage and home-equity line payments timely. In April 2006, when their outstanding principal balances on the first mortgage and the home-equity line were $265,000 and $100,000, respectively, they stopped making payments. The residential real estate market also weakened in 2006 as prices steadily fell throughout the year.

In December 2006, A sold the property at a foreclosure sale for $340,000 and was paid back the outstanding balance of its loan of $265,000. B was not as fortunate and was paid only $75,000, leaving a deficiency of $25,000 that B forgave. B sent M and S a 2006 Form 1099-C reporting DOI income of $25,000.

What are the tax consequences of this transaction?  When property burdened by recourse debt is foreclosed (or transferred to the lender in a deed-in-lieu-of-foreclosure transaction) and the debt exceeds the property’s FMV, the transaction is treated as a deemed sale for a price equal to the FMV. The deemed sale will trigger a gain on the sale of M and S’s home of $40,000 ($340,000 foreclosed bid – $300,000 basis) in 2006. Since B discharged the $25,000 deficiency, M and S will also realize $25,000 DOI income in 2006, which will be fully taxable unless they are bankrupt or insolvent.

The good news is that the $40,000 gain on the sale should be eligible for exclusion under the Sec. 121 home sale gain exclusion (Sec. 121; Regs. Sec. 1.121-1). This gain exclusion cannot shelter the DOI income because DOI income does not count as home sale gain. The DOI income arises in a separate transaction between borrower and lender and is taxable unless one of the exceptions under Sec. 108 applies.

Foreclosure by Lender: Nonrecourse Debt

Although nonrecourse home mortgages are not very common, they are worth briefly discussing because the tax treatment of nonrecourse debt forgiveness is different than the forgiveness of recourse debt.

A foreclosure (or deed in lieu of foreclosure) transaction involving non-recourse debt is treated as a deemed sale by the borrower to the lender with proceeds equal to the amount of nonrecourse debt (Tufts, 461 US 300 (1983)). The deemed sale will trigger a gain if the nonrecourse debt amount exceeds the home’s tax basis.

Treating the full amount of nonrecourse debt principal as the amount realized from a deemed sale means there can be no DOI income due to a foreclosure or deed-in-lieu-of-foreclosure transaction involving only nonrecourse debt. Unlike the treatment of foreclosures involving re-course debt, the FMV of the property is irrelevant. Also, insolvent or bankrupt status of the taxpayer does not affect the results. 

Example 3—foreclosure on a principal residence with nonrecourse debt: Using the same facts as Example 2—except that the mortgage and home-equity line are nonrecourse debt—the deemed sale will trigger a gain of $65,000 on the sale of M and S’s home ($365,000 nonrecourse debt – $300,000 basis) in 2006. There is no DOI income because the debt is nonrecourse. Because M and S meet the Sec. 121 qualifications, the gain should be excludible from gross income.

Observation: This tax outcome is generally unfavorable for bankrupt or insolvent taxpayers who can exclude DOI income from taxable gross income because foreclosures to satisfy nonrecourse debt may result in nonexcludible gain rather than excludible discharge income.

Bankrupt or Insolvent Taxpayers

A detailed discussion of when DOI income is not taxable is beyond the scope of this item. However, two of the more common exceptions, bankrupt and insolvent taxpayers, are worth noting.

Special mandatory relief provisions apply to the DOI income of bankrupt or insolvent taxpayers (Sec. 108(a)). These relief provisions allow such taxpayers to exclude DOI income from gross income. However, the borrower may have to reduce certain tax attributes (i.e., net operating and capital loss carryovers, tax credit carryovers, basis in property, etc.) by the amount of DOI income treated as tax free under these exceptions (Secs. 108(a) and (b)).

Bankrupt taxpayers may exclude all DOI income from gross income under these rules (Sec. 108(a)(1)(A)). Insolvent taxpayers may exclude DOI income from taxable gross income to the extent of insolvency before the debt discharge transaction. Any DOI income in excess of insolvency is included in gross income.

Example 4—excludible DOI income for insolvent taxpayer: R’s sole proprietorship business failed in 2006. At the time, he owed $500,000 in business operating debts to Local Bank. His business also owns land free and clear (worth $350,000) that he holds for investment. The bank discharged $200,000 of R’s debts. This debt discharge occurs outside of bankruptcy in a voluntary workout between lender and borrower. Just before the debt discharge, R was insolvent to the extent of $150,000. Thus, he can exclude $150,000 of the $200,000 DOI income. However, he must reduce his tax attributes by up to $150,000. The remaining $50,000 of DOI income must be included in his income. After the debt discharge, R’s assets are still worth $350,000, and his liabilities are only $300,000. Thus, $50,000 is taxable because he has been made solvent by that amount as a result of the debt discharge transaction.

Conclusion 

It is important to understand that a real estate short sale or foreclosure can potentially result in taxable gain on the sale of a home, taxable DOI income, or both. The good news is that taxpayers can probably exclude some or all of the home sale gain if the homeowner meets the qualifications of Sec. 121, and they might also be able to exclude some or all of the DOI income.

EditorsNotes

Frank J. O’Connell, Jr., CPA, Esq, Crowe Chizek, Oak Brook, IL.

Unless otherwise noted, contributors are independent members of Crowe Chizek.

If you would like additional information about these items, contact Mr. O’Connell at (630) 574-1619 or foconnell@crowechizek.com.