Foreclosure ATG - Chapter 9 - Audit Strategies
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.
- Summary of Real Estate Property Audit Strategies
- Case File Documentation
- Standard Paragraphs and Explanation of Adjustments
- Job Aids
- Resources for Real Estate Foreclosures and Cancellation of Debt Income
Summary of Real Estate Property Audit Strategies
When a taxpayer defaults on a loan or abandons their property, they may not have documents related to the sale of the property. Consequently, summonsing third parties (or third party records) may be necessary. The following list summarizes the audit strategies discussed in this guide.
- During the initial interview, ask the taxpayer questions to establish the facts and circumstances that led to the disposition or loan modification. If CODI was excluded from income, establish whether the taxpayer qualified to exclude income under the exclusion.
- Pull property records upon receipt of a case to identify property owned and disposed of and all loans associated with the property.
- A reconciliation of the IRP to the return is a required Minimum Income Probe step
- (IRM 22.214.171.124.2 Nonbusiness returns and IRM 126.96.36.199.3 Business returns). During this reconciliation, review the IRP for issuance of a Form 1099-A and/or Form 1099-C. This will help to identify whether or not an income issue exists, because the taxpayer may not have reported a foreclosure or other type of disposition on the tax return.
- Request the taxpayer's calculation of CODI and gain/loss of a property. Ask about any large, unusual, or questionable items and ask for supporting documentation when warranted.
- All mortgages should be included in the calculation of gain/loss and CODI. (Note: lenders, erroneously, do not always issue Forms 1099-C on all mortgages, especially second mortgages, or where the second mortgage is from a different lender). Review property records and consider looking at prior years' IRP for Forms 1098. These documents will identify whether the debt was being paid and, possibly, whether the debt should be considered in the disposition calculation(s).
- Review the final HUD-1 for loan modifications and dispositions. There are a few federal, state, and lender incentives that the taxpayer may qualify for. Identify whether a loan modification incentive received is taxable. For dispositions (e.g., short sales), a taxpayer may receive funds to cover relocation expenses. This may be listed on the HUD-1 as "relocation assistance". This amount generally is taxable and should be included in the sales price on Schedule D or Form 4797.
- When loan or sales information is in question, request the final HUD-1 from the lender or search public property records for recorded loan information, foreclosure notices, grant deed and/or title transfer for the disposition. The taxpayer might not have a copy of these documents if the home was foreclosed or disposed through a deed in lieu of foreclosure. These documents will identify pertinent information such as, the sales amount, date of title transfer, identifiable event, etc.
- Note that the final HUD-1 may not list the total debt owed at disposition. The HUD-1 will show the sales price and the amount of the proceeds that will be applied towards the loan balance right before the sale. You will need to add the amount forgiven to the sales price to identify the approximate amount owed right before the disposition. Also, review property records, the last monthly loan statement, loan documents, and/or other documents to identify the loan balance owed right before the disposition.
- Request purchase and refinance documents to determine the adjusted basis. Ask the taxpayer how the funds were used if the property was refinanced. Any amount used for personal purposes is not qualified indebtedness under the principal residence, farm, and real property business exclusions.
- Request a copy of the insolvency calculation. Ask about any questionable items and request supporting documentation when warranted. Refer the taxpayer to Publication 4681 to complete the insolvency worksheet if insolvency is claimed during the audit. The insolvency exclusion is not an election and can be utilized even during an examination.
- As part of the insolvency calculation, look for any liabilities that should have a corresponding asset. For example, if a car loan is listed, the fair market value of the vehicle should be listed under assets, unless the vehicle was repossessed.
- Generally, mortgage lenders will conduct an appraisal of the property during a short sale process. Therefore, a comparison of the fair market value on the Forms 1099-A and/or 1099-C with the taxpayer's insolvency calculation can be done to identify any differences. If you do identify any differences, request that the taxpayer explain how they determined the fair market value of the property particularly if the difference puts the taxpayer in an insolvent position.
- Sometimes taxpayers attempt to convert their principal residence into rental real estate property right before it forecloses. Then, the losses and non-deductible personal expenses (e.g., property insurance) are deducted as passive losses and deductions, respectively. Determine why the taxpayer converted the residence to a rental and whether it was formally the taxpayer's principal residence or second home and the resulting tax consequences. Evaluate whether the conversion was temporary or a permanent conversion to a valid rental activity.
- Non-issuance of a Form 1099-C does not relieve taxpayers of their responsibility to include CODI in income. Identify all loans on the property by reviewing IRP and property records. All loans should be considered in the CODI and gain/loss calculations.
- Consider state foreclosure laws for the state where the property is located. For example, at times taxpayers are not issued Form 1099. The state law will help to determine whether the lender forgave any debt.
- When CODI, Form 4797 gain/loss or Schedule D gain/loss, and Schedule E gain/loss for all years are netted and result in a loss, consider whether the taxpayer is "poorer" by that amount. If the taxpayer could not afford to sustain that loss then how did he/she fund the losses (e.g., other debt, current year income, or other assets)?
Case File Documentation
Cases involving foreclosures should include the following information/documentation:
- Any document that helps to provide a financial picture of the taxpayer at the time of the foreclosure. For example, house and car loans, credit card bills, utility bills, earnings statements, bank statements, check registers, investment statements, etc.
- Any information evidencing that the debt was not in fact collected
- Any Forms 1099-C or Forms 1099-A
- Completed Form 433-A, Collection Information Statement for Wage Earners and Self-Employed Individuals, and/or Form 433-B, Collection Information Statement for Businesses, along with supporting documentation (as warranted)
- Results of any interview with the taxpayer
- Documents collected from the taxpayer as a result of an interview
- Bankruptcy documents (such as the bankruptcy petition and plan) if the taxpayer filed a Chapter 7, 11, 12 or 13 bankruptcy at the time of the foreclosure.
Standard Paragraphs and Explanation of Adjustments
See IRM 4.10.10, IRM Exhibit 4.10.10-1, and IRM Exhibit 4.10.10-2.
Job Aid 1 – Insolvency Worksheet located in Publication 4681:
Publication 4681 (PDF), Canceled Debts, Foreclosures, Repossessions, and Abandonments (for Individuals)
Job Aid 2 – Sample HUD-1:
Job Aid 3 – Sample Information Document Request:
Only the applicable information as it relates to the taxpayer should be requested.
- Was the loan(s) that secured the property recourse or nonrecourse? Provide the documentation relied upon to make this determination.
- What information was relied upon to determine the gross sales price?
- How was the cost basis determined?
- If cancellation of debt was excluded from income, provide the last loan statement showing the balances for all loans that secured the property right before the foreclosure, deed in lieu of foreclosure or short sale.
- Provide documentation to support the exclusion of cancellation of debt income (e.g., insolvency, farm, or real property business computations).
- Provide bankruptcy discharge documents.
- Provide attribute reduction calculations, as applicable.
- What method of depreciation was used to depreciate the disposed property?
- Provide a copy of the final HUD-1 or other document(s) for the sale of the property.
- Did you receive any relocation assistance funds or other monies under a program? If yes, how much was received and how was it reported on the tax return?
- Was the loan(s) refinanced anytime during ownership of the property? If yes,
- How much was received?
- How were the funds used?
- Provide a copy of the original purchase loan documentation.
- Provide a copy of the refinanced loan documentation.
- If the property was refinanced and funds were totally or partially used for the property, provide documentation (e.g., invoices, receipts) that shows the amount and type of expense.
Document Request for a Loan Modification
- Was any money received from the lender as a result of a loan modification? If yes, provide the amount received and how it was used.
- Was any money received under a Home Affordable Program? If yes, provide the amount and where this amount was reported on the tax return. If the amount was nontaxable, provide the name of the Home Affordable Program or other program and information that explains the funds were nontaxable.
- Provide documentation to support the exclusion of cancellation of debt income (e.g., bankruptcy, insolvency, farm, or real property business computations).
- Provide documentation to support that the property was used as a principal residence (e.g., utility bills, driver's license, etc.). [Note to examiner: This issue is very factual driven meaning that requested documentation would depend on the facts and circumstances].
- Provide a copy of the HUD-1 for the loan modification.
Job Aid 4 – Sample Initial Interview Questions – Principal Residence:
- What is your current address?
- How was the property disposed? (For example, abandonment, foreclosure, deed in lieu of foreclosure, or short sale).
- Provide a brief history of the events that led to the foreclosure.
- Where did you live before and after the foreclosure?
- What date did you move?
- What date was the property purchased?
- How was the sales amount reported on your return determined?
- Did the lender give you a monetary incentive to vacate the property? If yes, how much? Was this amount included in the sales amount reported on the return?
- How was the cost basis determined?
- Did you refinance during anytime of your ownership of the residence? If yes,
- How much did you receive?
- How were the funds used? (Need amount used for the residence and amount used for other purposes).
- Was the property used as rental property anytime during ownership? If yes, when? How much? Was the property rented for fair rental value? etc.
- Did the lender forgive you of the outstanding balance after the residence was sold?
- If yes, did you receive a Form 1099-C? Was it accurate? What was inaccurate?
- If no, did the lender receive a deficiency judgment? How much? How are you paying for the deficiency?
- If the cancellation of debt income was excluded from income under the qualified principal residence indebtedness exclusion, was the refinanced amount considered in the amount excluded from income? (Non-qualified portion may be taxable CODI).
Resources for Real Estate Foreclosures and Cancellation of Debt Income
Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments
This publication explains the federal tax treatment of canceled debts, foreclosures, repossessions, and abandonments.
Passive Activity Loss Audit Technique Guide
This Audit Technique Guide provides examiners with specific guidance on potential audit issues, issue identification, lead sheets, and other job aids.
The U.S. Department of Housing and Urban Development
The Department of Housing and Urban Development administers programs that provide housing and community development assistance. The Department also works to ensure fair and equal housing opportunity for all.
Partnership Audit Technique Guide Chapter 8 Real Estate Issues in Partnerships
This Audit Technique Guide provides examiners with specific guidance on potential audit issues, issue identification, lead sheets, and other job aids. Real estate issues in partnerships are covered in chapter 8.
Farmers Audit Technique Guide Chapter Eleven Other Issues
This Audit Technique Guide contains examination techniques, common and unique industry issues, business practices, industry terminology, and other information to assist examiners in performing examinations. Cancellation of indebtedness is covered in chapter 11.