TAX LIABILITY INCURRED BY HOMEOWNERS THROUGH SHORT SALE OR FORECLOSURE
There has been a lot of discussion over the past two months regarding California SB 458. The new law, in effect since July 2011, bars banks from filing a deficiency action against homeowners for the difference between the sale price and the amount owed to the bank secured by notes. The new law extends this protection against junior lien holders. While this is good news for most homeowners that decide a short sale is best for their primary residence, it does not address the tax consequences of that decision.
The Mortgage Debt Relief Act of 2007 generally allows taxpayers to exclude income from the cancellation of debt on their principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure and short sale qualifies for the relief. This law expires on December 31, 2012.
California law conforms with modifications to federal mortgage forgiveness debt relief for discharges that occurred in tax years 2007 through December 31, 2012. The amount of qualifying indebtedness is less than the federal amount and California imposes a state-only limitation on the total amount of relief excluded from gross income.
This is all good news for homeowners if they find themselves in a situation where they need to sell their home through short sale or the home goes to foreclosure. However, there are limitations that must be taken into consideration when deciding if a short sale or foreclosure is an option.
In order to determine if you qualify for SB 458 protection and the Debt Relief Act of 2007 protection you must first determine what cancellation of debt includes.
What is Cancellation of Debt? (http://www.irs.gov/individuals/article/0,,id=179414,00.html)
If you borrow money from a commercial lender and the lender later cancels or forgives the debt, you may have to include the cancelled amount in income for tax purposes, depending on the circumstances. When you borrowed the money you were not required to include the loan proceeds in income because you had an obligation to repay the lender. When that obligation is subsequently forgiven, the amount you received as loan proceeds is normally reportable as income because you no longer have an obligation to repay the lender. The lender is usually required to report the amount of the canceled debt to you and the IRS on a Form 1099-C, Cancellation of Debt.
There are some exceptions. The most common situations when cancellation of debt income is not taxable involve:
• Qualified principal residence indebtedness: This is the exception created by the Mortgage Debt Relief Act of 2007 and applies to most homeowners. The Act applies only to forgiven or cancelled debt used to buy, build or substantially improve your principal residence, or to refinance debt incurred for those purposes. In addition, the debt must be secured by the home. This is known as qualified principal residence indebtedness.
• Bankruptcy: Debts discharged through bankruptcy are not considered taxable income.
• Insolvency: If you are insolvent when the debt is cancelled, some or all of the cancelled debt may not be taxable to you. You are insolvent when your total debts are more than the fair market value of your total assets.
• Certain farm debts: If you incurred the debt directly in operation of a farm, more than half your income from the prior three years was from farming, and the loan was owed to a person or agency regularly engaged in lending, your cancelled debt is generally not considered taxable income.
• Non-recourse loans: A non-recourse loan is a loan for which the lender’s only remedy in case of default is to repossess the property being financed or used as collateral. That is, the lender cannot pursue you personally in case of default. Forgiveness of a non-recourse loan resulting from a foreclosure does not result in cancellation of debt income. However, it may result in other tax consequences.
One of the most common issues with qualifying for the Mortgage Debt Relief Act of 2007 is for loans that were refinanced and the value of the home has dropped below that value.
If a homeowner’s original mortgage was for $450,000 in 2004 and refinanced for in 2007 to make improvements to the home leaving the current balance $600,000 the homeowner would qualify for the Debt Relief Act of 2007 so long as the value of the home is at least $600,000. However, if the home was sold for $500,000 in a short sale, the remaining balance of $100,000 would be outside the protection of the Mortgage Debt Relief Act of 2007.
The problem that most homeowners are facing is the drop in value of their home from the value when the home was refinanced. Remember that the protection is only available to principal residence.
Property other than principal residence
The federal Mortgage Forgiveness Debt Relief Act only provides for the exclusion of Cancellation of Debt (COD) income relating to qualified principal residence. If you have COD income as the result of a foreclosure or short sale on other property, such as a second (vacation) home, rental, or other business property, you may still be able to exclude COD income under other provisions if:
- You were discharged the debt through bankruptcy.
- You were insolvent (limited to level of insolvency).
- Qualified farm indebtedness was canceled.
- Debt was Qualified Real Property Business Indebtedness (QRPBI) and you make a federal election.
If you would like to discuss the best option for your personal financial situation regarding a short sale, foreclosure or bankruptcy, please feel free to contact us at 925.454.4460 or send an e-mail to firstname.lastname@example.org