Foreclosure ATG - Chapter 1 - Overview
Publication Date - February 2015
NOTE: This guide is current through the publication date. Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.
- Brief History
- Key Tax Issues
This guide discusses the tax consequences for real estate property that is disposed of through foreclosure, short sale, deed in lieu of foreclosure, and abandonments. Although, the term foreclosure is used throughout this document, the tax treatment also applies to short sales, deed in lieu of foreclosures, and abandonments. A discussion is also devoted to cancellation of debt income exclusions that are most commonly applicable to these types of dispositions and community property considerations. This guide primarily focuses on tax consequences for individual taxpayers. Keep in mind that the examples presented in this Audit Technique Guide are general examples and should not solely be relied upon for every situation as each fact pattern may change the tax consequences.
According to the U.S. Department of Housing and Urban Development (HUD) and the U.S. Department of the Treasury's December 2013 Housing Scorecard, 3.6 million cumulative completed foreclosures occurred from April 2009 through October 2013. This number includes investment, second home, and jumbo mortgage properties (high-end properties).
Many taxpayers were unaware that even though their lender foreclosed on their properties, there could be tax consequences and the lender could legally pursue collection of any outstanding deficiency. In 2009, the government stepped in to help distressed homeowners and implemented various assistance programs, such as the Making Home Affordable Program, as a strategy to help homeowners avoid foreclosure, stabilize the country's housing market, and improve the nation's economy. Federal and State governments have filed numerous lawsuits against lending institutions for unfair and/or fraudulent practices. As a result, mortgage lenders have implemented changes.
Internal Revenue Code §61(a)(12) provides that gross income includes income from discharge of indebtedness. When money is borrowed, the loan proceeds are not included in income because an obligation to repay the lender exists. Generally, when debt for which a taxpayer is personally liable is subsequently forgiven, the amount received as loan proceeds is reportable as income because an obligation to repay the lender no longer exists, which results in an economic benefit to the taxpayer.
Under IRC §108(a) taxpayers may exclude discharged debt if the taxpayer is bankrupt, insolvent, the discharged debt is qualified farm indebtedness, the discharged debt is qualified real property business indebtedness, or if the discharged debt is qualified principal residence indebtedness. Form 982 is completed to report the exclusion and the reduction of certain tax attributes either dollar for dollar or 33 1/3 cents per dollar.
PLR 8918016, 1989 WL 595222, states that, "[A]ccording to legislative history of the Bankruptcy Tax Act of 1979, the purpose of IRC §108 is to accommodate both tax and bankruptcy policies. Due to the Supreme Court's decision in United States v. Kirby Lumber Co., 284 U.S. 1 (1931), tax policy requires debtors to include in gross income the amount of debt they are no longer required to repay, including debts discharged in bankruptcy."
The Mortgage Forgiveness Debt Relief Act of 2007 is a well-publicized act that allows qualifying taxpayers to exclude debt discharged as income from a borrower's principal residence. Consequently, IRC §108(a)(1)(E) was added to the Internal Revenue Code.
Gifts, deductible debt, and purchase price reduction are exceptions to IRC §61(a)(12) where discharged debt is not taxable. These exceptions apply before the exclusions under IRC §108(a)(1) and do not require a reduction of tax attributes.
If forgiveness of the debt is a gift, then generally, it is not considered income. However, the donor may be required to file a gift tax return.
Deductible Debt (lost deduction)
If the payment of the debt would result in a deduction, then the cancellation of the debt is not included in gross income. For example, Marvin was discharged of $50,000 ($20,000 principal and $30,000 interest) of mortgage debt. If Marvin would have made the mortgage payments, he may have been able to deduct the $30,000 as mortgage interest expense on his tax return. Since Marvin did not make his mortgage payments, the $30,000 is a lost deduction. Thus, Marvin's cancellation of debt income is $20,000.
Purchase Price Reduction
If the seller reduces the amount of debt owed for property purchased, the reduction generally does not result in cancellation of debt income. The reduction of the debt is treated as a purchase price adjustment and reduces the property's basis. In comparison, if a bank or financial institution that holds the mortgage note reduces or modifies the balance of the loan, the debt restructure is treated as a loan modification and is not considered a purchase price reduction. For example, Jane purchased a residence from Jamie and obtains a mortgage loan from a third party, Adam. During escrow, Jamie decides to reduce the purchase price of the property due to a problem discovered during the house inspection. Jamie's reduction of the purchase price is considered a purchase price reduction and not cancellation of debt.
Foreclosure – A legal procedure by which mortgaged real estate property is sold by the lender in full or partial satisfaction of the mortgage debt. For example, if the borrower fails to pay the monthly mortgage payments, the lender takes the property back and sells it to recover some or all of the debt. If proceeds from the sale fail to pay recourse debt in full, the lender may obtain a deficiency judgment in court to recover the outstanding balance. The foreclosure proceeding and whether the lender is able to obtain a deficiency judgment is determined by the law of the state where the property is located.
Short sale - A sale of mortgaged real estate property in which the proceeds from selling the property will fall short of the total balance owed by the borrower. Short sale agreements do not necessarily release the borrower from their obligation to repay any loan deficiency unless specifically agreed to between the lender and property owner and governing state law.
Deed in Lieu of Foreclosure – The borrower returns the property back to the lender in full satisfaction of the mortgaged outstanding debt balance upon an agreement by the lender. The principal advantage to the borrower is that it immediately releases him/her from most or all of the personal indebtedness associated with the defaulted loan.
Nonrecourse Debt – The borrower is not personally liable and repossession of the mortgaged property, for example, will generally satisfy the outstanding debt.
Recourse Debt – The borrower is personally liable for the loan. Meaning, the lender can obtain a deficiency judgment against the borrower in court for any outstanding balance that is not satisfied through a foreclosure sale. State law of where the property is located governs whether the lender is able to obtain a deficiency judgment.
Cancellation of Debt Income (CODI) – Also known as cancellation of indebtedness income (COII) – If a lender forgives a borrower of all or part of an outstanding debt owed, the borrower is considered to have received a benefit that has put him/her into a better financial position. The amount of the benefit must be reported as income received under IRC §61(a)(12), unless the taxpayer qualifies for an income exclusion under IRC §108.
Home Affordable Modification Program - Any Pay-for-Performance Success Payments that reduce the principal balance of the home mortgage under the Home Affordable Modification Program are not taxable.
HUD-1 Settlement Statement (Job Aid 2) - This form is used as a statement of actual charges and adjustments paid by the borrower and the seller. The concept is similar to that of the T-account where all incoming and outgoing amounts of the real estate transaction are listed. Both parties receive a copy of this statement before or at closing.
Relocation Assistance - Some taxpayers qualify for relocation funds to assist with moving expenses. These programs are offered through federal, state and local government, and lenders. The taxpayer may receive monies for their principal residence, rental property and investment property. These funds are taxable and included in the gain/loss computation.
Key Tax Issues
Foreclosure issues may not be as cut and dry as Schedule C advertising expenses and are very factual, circumstantial and specific. One fact or circumstance could change the result of how the foreclosure is reported on the return. Questions should be asked and documents gathered that will address the issues of whether the foreclosure, short sale or deed in lieu of foreclosure resulted in a recognized gain or loss and cancellation of indebtedness income, and how these amounts should be reported on the taxpayer's tax return. Other issues arise when a taxpayer excludes cancellation of debt income. Chapter 9, Audit Strategies, includes a discussion on case file documentation, job aids, resources, and contact information. For example, Job Aid 2 is a sample IDR and Job Aid 3 contains sample interview questions for the disposition of a principal residence.
Foreclosures, short sales and deeds in lieu of foreclosure are considered dispositions. Keep in mind that if a taxpayer is involved in a short sale he/she will know the date the property was sold and the sales amount, because he/she will work closely with the real estate agent and lender during the short sale process. The closing HUD-1 (Job Aid 4) will show the amount of the loan that will be satisfied by the sale. The total loan balance will conceptually be equal to the amount on the closing HUD-1 and the amount of debt forgiven. In comparison, a taxpayer does not become aware of the identifying information regarding a disposition through a foreclosure, until after the lender sells the property and generally issues a Form 1099-C.
Once a lender repossesses real estate property through a foreclosure or the lender becomes aware that the property owner abandoned the property, the lender should issue the taxpayer a Form 1099-A (Acquisition or Abandonment of Secured Property). If the lender also forgives or cancels part or all of the outstanding debt, a Form 1099-C (Cancellation of Debt) should be issued to the taxpayer. If the lender forecloses on the property and forgives the debt within the same year, then the lender is only obligated to issue a Form 1099-C for debt canceled of $600 or more. The taxpayer should contact the bank if the information is incorrect so that corrected forms are issued.
Confusion arises when a taxpayer receives a Form 1099-A in one year and a Form 1099-C in a subsequent year for a recourse note. A foreclosure is a disposition within the meaning of IRC §1001 (Helvering v. Hammel, 311 U.S. 504 (1941)). The foreclosure sale ends the mortgagor's ownership in the property, and at that time, the gain or loss from the sale or other disposition of the mortgaged property should be determined (Helvering v. Hammel, 311 U.S. 504 (1941)). Refer to discussion in Chapter 2, Nonrecourse and Recourse Debt for additional information.
The Service has observed that lenders may issue Forms 1099 only for the primary loan. All property loans should be considered in the determination of any cancellation of debt income as well as gains or losses. Therefore, it is important to ask the taxpayer questions about the events leading up to and after the disposition. To identify all loans associated with the disposed property, search property records and IRPTR, or review prior years' returns for mortgage interest. Sometimes a lender may erroneously fail to issue the taxpayer a Form 1099-C. Facts and circumstances will dictate when or if any outstanding debt has been discharged, absent the issuance of a Form 1099-C. Under IRC §7491(a)(1), under certain circumstances, in any court proceeding, the burden shifts to the IRS to prove that the taxpayer received cancellation of indebtedness income if the taxpayer provides creditable evidence with respect to any factual issue relevant to ascertaining the income tax liability of the taxpayer. See discussion later on Form 1099-A and Form 1099-C.
Consideration of whether the lender has pursued collection activity and the state where the property is located are two primary factors. Each state has its own foreclosure legal laws and time frames that a lender must pursue collection activities. Absent a Form 1099-C, it is reasonable to conclude that the taxpayer was forgiven the outstanding balance if the lender has not pursued collection activity in accordance with the state law of the location of the property. For example, if a foreclosure is completed by non-judicial means in some states, the lender is precluded from pursuing a deficiency judgment for the outstanding balance.
Some states, shown in Table 1, Anti-Deficiency/Nonrecourse States, have anti-deficiency laws which prohibit a lender from pursuing a deficiency judgment against the borrower under certain circumstances. Although, these states are identified as Anti-Deficiency states, it is important to note that each of these states has its own rules and the anti-deficiency rules are not applied in the same manner. It is important to understand the state law where the property is located as it could make a difference in the amount of income includable in taxable income or excludable from taxable income.
It is advised to seek assistance from local Counsel for specific state questions regarding foreclosures. Refer to the Local Law Section in IRM 5.17, Legal Reference Guide for Revenue Officers for more information.
In general, if indebtedness is canceled or forgiven, the amount canceled or forgiven must be included in gross income. If CODI is excluded from income, it generally will postpone the income tax liability on cancellation of indebtedness through the reduction of tax attributes.