As a follow up to Mike Chesser’s article, “Mostly Unwanted Advice for ‘Short-Sellers’ and for Owners of Property in Foreclosure”, I have been asked to provide a general overview of some of the possible tax consequences facing homeowners in foreclosure or considering a short sale. The tax law discussed in this article is over simplified and is not intended to take the place of a qualified tax advisor. Therefore, each homeowner in foreclosure or considering a short sale should seek the services of an experienced real estate attorney and a qualified tax advisor to plan appropriately.
Many homeowners who are facing foreclosure or contemplating a short sale will be distressed to learn that there are possible income tax consequences facing them as a result of either event. The income tax treatment for both a foreclosure and a short sale is basically the same so, for ease of reading, let’s refer to both a foreclosure and a short sale as “the transfer”. Upon the occurrence of the transfer, the homeowner may have 1) Cancellation of Indebtedness Income (CODI) to the extent discharged debt exceeds the fair-market-value of the property and 2) gross income if the cancelled debt (or amount received) is greater than the amount the homeowner has in his or her property. There are, however, exceptions to the above tax consequences. If the discharged debt that created CODI resulted from a loan used by the homeowner to acquire or improve the home, then the homeowner will not be required to include CODI for 2012. Here, I need to stress that this exception will no longer be available at year’s end unless Congress decides to act. There are other exceptions to the inclusion of CODI but the one applicable solely to personal residence indebtedness will expire this year unless extended. Additionally, as to the gross income from the gain on the home, if the homeowner used the home as his or her principal residence for periods aggregating two (2) years or more during the five year period immediately before, and ending on, the date of the transfer, then the homeowner will be able to exclude some, if not all, of the gain.
Many of us probably have no problem accepting that we realize a gain if the amount received is greater than our investment in our property, but CODI may be a bit much for some to accept. In its wisdom, Congress defined gross income as including all income “from whatever source derived” and this definition specifically includes CODI. When each of us borrow money from a lending institution, we do not have to include the loan proceeds in gross income because of the concurrent obligation to repay the borrowed funds. In short, there is no accession to wealth because, at the end of the day, the taxpayer is no better off financially from borrowing the money. When the obligation to repay the debt is removed, the taxpayer was actually better off financially from borrowing because his or her assets (when viewed before the funds were invested in a home) were increased. This increase in assets is accession to wealth and satisfies the definition of gross income because the definition of gross income includes income from “whatever source derived”. Granted, a homeowner in such a situation who owes more on his or her house would disagree on the accession to wealth, but this viewpoint considers how the funds were ultimately invested, not solely on the money borrowed and the subsequent forgiveness of that debt. Regardless if the rationale is accepted by some or all, it is the law, so we must account for it and plan accordingly.
To tie together most of the above tax considerations, the following example should help:
Bart paid $200,000 for his home in Springfield in 2001. He paid $15,000 down and borrowed the remaining $185,000 from a bank. Bart is personally liable for the loan and the house is pledged as security for the loan. Bart has used the home as his principal residence since he purchased the home in 2001. In 2012, the bank foreclosed on the loan because Bart stopped making payments. When the bank foreclosed, the balance due was $180,000, the fair-market-value of the home was $170,000, and Bart’s basis (cost of the property + money invested for improvements – deductions) in his home was $150,000 due to a casualty loss he had deducted. At the time of the foreclosure, the bank forgave all of the $10,000 debt in excess of the fair-market-value ($180,000 minus $170,000).
In this case, Bart has CODI in the amount of $10,000. The amount is determined by subtracting the fair-market-value of the home from the total outstanding debt immediately before the transfer. Here, since Bart’s debt was qualified personal residence indebtedness, he will be able to exclude the $10,000 from his ordinary income by using one of the exceptions discussed earlier. This exception, however, would not been available to Bart if the foreclosure occurred in 2013. The same is true if Bart had entered into a short sale as opposed to having the bank foreclose.
Bart must also now determine his gain or loss from the foreclosure. In this case, the amount that Bart realized is $170,000. When the amount realized is compared to Bart’s basis (cost of the property + money invested for improvements – deductions) in his home, we see that Bart has a gain on the foreclosure of $20,000. But this gain will be excluded from Bart’s gross income since the home was used as his principal residence.
Here, in the above example, we have a somewhat happy ending for Bart from a tax perspective, but this example could have easily been much more complicated if a few facts were changed. Let’s suppose that Bart refinanced his home during the housing market boom and some of the loan proceeds were not used to improve the home, but instead, was used to purchase a boat. This portion of the debt would be CODI and not qualify for any of the available exceptions. Likewise, let’s suppose that Bart converted his home from vacation home to his principal residence but failed to meet the time requirement of having used the home as his principal residence for two (2) years during the previous five (5) year period. As such, Bart would have to report the gain as part of his gross income.
A person’s individual circumstances go a long way in determining his or her taxes. As such, anyone facing foreclosure or who is considering a short sale should seek the services of an experienced real estate attorney and a tax professional to properly plan.