By Robert S. Kutner, Esq.
Potential income tax consequences have made many homeowners reluctant to list their homes for sale, particularly where the amount needed to pay off their mortgages exceeds the value of their homes. They fear that a short sale would result in a large income tax bill.
Forgiveness Debt as Income
A “short sale” is simply a sale in which a seller and lender agree to accept a price lower than the value of the loans secured by the property. Prior to a change in federal law in 2008, the IRS generally treated forgiveness of a debt as the equivalent of receipt of taxable income. The rationale was that when money was borrowed, the borrower was not required to include the loan proceeds as income because the borrower had an obligation to repay the lender.
When that obligation was forgiven, the amount received as proceeds by the borrower became reportable as income because there was no longer an obligation to repay. The tax treatment is different where the loan is a “non-recourse” loan, namely, one where the lender does not have the right to pursue recovery of the shortfall from the homeowner.
The treatment of forgiveness of recourse debt as income in a 2003 sale was the focus of a decision of the US Tax Court in Stevens v. Commissioner. To avoid foreclosure, the Stevens’ had approached their lender in 2003, proposing a short sale of their property. The lender agreed, even though the selling price was substantially less than the Stevens’ owed.
At the end of the tax year the lender sent the Stevens’ a Form 1099-C reporting that it had forgiven the Stevens’ $74,494 in debt. As a result, the IRS determined that the Stevens’ 2003 tax return had a deficiency of $21,323. Based on the historic treatment of debt forgiveness as income, the Tax Court upheld the IRS determination.
Mortgage Forgiveness Debt Relief Act of ‘07
To avoid the hardship caused to thousands of borrowers, Congress passed legislation in December 2007 that granted relief, provided that the owner satisfied specific requirements. According to the Mortgage Forgiveness Debt Relief Act of 2007, taxpayers may exclude forgiven debt that was “qualified principal residence indebtedness,” namely: (1) is on the borrower’s principal residence; (2) was used to buy, build, or substantially improve the taxpayer’s principal residence; (3) is secured by that residence; and (4) has a loan balance of $2 million or less. The limit is $1 million for a married person filing a separate return.
When originally enacted, the law only applied to property sales and debt forgiven in 2007, 2008, or 2009. It has since been extended through 2012. Debt used to refinance qualifying debt is also eligible for the exclusion, but only up to the amount of the mortgage principal owed before the refinancing. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, may qualify for this relief.
Debt forgiven on second homes, rental property, business property, credit cards, or car loans does not qualify for the new tax-relief provision. In some cases, however, other kinds of tax relief, based on insolvency, for example, may be available. The exclusion does not apply if the discharge is due to services performed for the lender, or for any other reason not directly related to a decline in the home’s value or the taxpayer’s financial condition.
Even if the debt that is forgiven does not qualify as “qualified principal residence indebtedness,” there may be other approaches that enable the homeowner to avoid treating a forgiven debt as taxable income. The forgiven debt may qualify under the insolvency exclusion. A person is insolvent when their total liabilities exceed their
assets. Forgiven debt may also qualify for exclusion if the debt was discharged in a Title 11 bankruptcy proceeding or if the debt is qualified real property business indebtedness.
Borrowers whose debt is reduced or eliminated will receive a year-end statement from their lender, IRS Form 1099-C. Eligible homeowners must complete several lines on IRS Form 982 which must be included when filing their federal income tax return to claim the mortgage relief. For more information, review IRS Publication 4681 and IRS Form 982, or consult a qualified accountant or attorney.