Tax Consequences for Foreclosure & Short Sale

The answer will vary depending on the facts specific to the individual, loans, and real property, but in generally, a discharge of debt from a foreclosure is excluded from taxation under Internal Revenue Code §108(a)(1)(E), if the real estate is a residential property that was occupied by the homeowner(s) as their principal residence and all of the debt incurred (and now discharged) was used to buy and/or improve the property.

Prior to 2007, a discharge of debt was a taxable event requiring reporting by a taxpayer. The characterization of discharge of indebtedness income as "ordinary income" or "capital gain" depends on whether the debt was recourse or non-recourse. Under the Tufts and Crane cases, where real property is foreclosed and the debt exceeds the fair market value of property, a taxpayer recognizes:

  1. cancellation of debt income (taxable as ordinary income) to the extent the debt (loan amount due) exceeds the fair market value of the property; and
  2. capital gains on the difference between the fair market value and the adjusted basis in the property. For non-recourse debts, the entire amount of the difference between the debt amount owed and the adjusted basis in the property is taxed as a capital gain.

These rules would come into play after December 31, 2012 (when the exception noted above expires), if the property does not qualify as a "qualified principal residence", or if the debt was not used to buy or improve the property.

Internal Revenue code §61 defines gross income to include income from "discharge of indebtedness" under IRC 61(a)(12). The exception, promulgated under the 2007 Mortgage Forgiveness Act (Pub. L. No. 110-142), provides an exclusion from income for debt forgiveness involving a mortgage on a principal residence. This exception lies under IRC 108(h), which defines “qualified principal residence indebtedness” as:

(h) Special rules relating to qualified principal residence indebtedness.--

(1) Basis reduction.--The amount excluded from gross income by reason of subsection (a)(1)(E) shall be applied to reduce (but not below zero) the basis of the principal residence of the taxpayer.

(2) Qualified principal residence indebtedness.--For purposes of this section, the term "qualified principal residence indebtedness" means acquisition indebtedness (within the meaning of section 163(h)(3)(B), applied by substituting "$2,000,000 ($1,000,000" for "$1,000,000 ($500,000" in clause (ii) thereof) with respect to the principal residence of the taxpayer.

(3) Exception for certain discharges not related to taxpayer's financial condition.--Subsection (a)(1)(E) shall not apply to the discharge of a loan if the discharge is on account of services performed for the lender or any other factor not directly related to a decline in the value of the residence or to the financial condition of the taxpayer.

(4) Ordering rule.--If any loan is discharged, in whole or in part, and only a portion of such loan is qualified principal residence indebtedness, subsection (a)(1)(E) shall apply only to so much of the amount discharged as exceeds the amount of the loan (as determined immediately before such discharge) which is not qualified principal residence indebtedness.

26 U.S.C.A. § 108.

Originally scheduled to expire after 2009, the program has been extended through 2012. The amount excluded reduces the property's basis. The provision applies to qualified debt up to $2 million and forgiveness in exchange for performing services is not excluded. If part of the loan is not qualified, the forgiveness is applied first to that part, and only the excess is excluded from income.

The information contained in this article is presented only for information purposes and may not be relied on as legal advice or construed as developing an attorney client relationship. If you need legal advice you should contact an attorney.

For more information, please contact our San Diego tax attorney at (844) 444-2889.

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