© 2012, 2013 by Michael C. Gray, CPA | January 3, 2013
Congress passed legislation permanently extending the Bush tax cuts on January 1, 2013. The title of the Act is American Taxpayer Relief Act of 2012, HR 8. A 39.6% tax rate was added for taxpayers who file joint income tax returns with taxable income of $450,000 or more, heads of household with taxable income of $425,000 or more and other singles with taxable income of $400,000 or more.
The legislation includes a one-year extension through December 31, 2013 of the exclusion from gross income of discharge of qualified principal residence indebtedness, discussed below.
California has enacted legislation relating to refinancing a residence, effective for refinancing happening on or after January 1, 2013. The details are explained below.
Our nation has experienced the effects of tightening mortgage credit after a liberal period. With increases in interest rates for adjustable rate mortgages and the conversion to amortization of principal for interest-only (or negative amortization) loans, home values for homes favored by subprime borrowers (and even other homes) have collapsed, and the debtors are either trying to “walk away” from their homes and allowing them to be foreclosed or are making “short sales.”
A “short sale” is selling the home for less than the mortgage balance and trying to get the lender to forgive the unpaid balance. This is a new use of the term, and is not the definition for this item in the Internal Revenue Code. In the tax law, a “short sale” is a sale of a borrowed item to be replaced at a future date, usually a security. The only case that I know about using the term “short sale” for this type of transaction is a 2008 decision, Stevens v. Commissioner.¹ With the explosion of real estate short sales, we will undoubtedly soon see more cases with them.
A reason for debtors to consider a “short sale” instead of a foreclosure is to try to protect their credit rating. California has adopted Senate Bill 458, which gives superior anti-deficiency protection for short sales of certain residential real estate compared to trust deed foreclosures. (Laws vary from state to state. Always consult with a real estate attorney relating to continuing liability after a short sale or foreclosure.)
How are foreclosures (and deeds in lieu of foreclosure) taxed?
An important consideration in the results of a foreclosure (or a deed in lieu of foreclosure) is whether the debt is “recourse” or “nonrecourse.” If the debt is “recourse,“ the debtor is personally liable for the debt. If the debt is “nonrecourse,” the debt is only secured by the property, and the debtor is not personally liable for the balance.
You should consult with an attorney to determine the status of your mortgage. In California, most mortgages that are used to purchase a residence are nonrecourse, but mortgages from refinancing a previous mortgage are usually recourse. You can’t always determine whether a mortgage is recourse from the note or paperwork.
When a nonrecourse mortgage is foreclosed, the property is treated as being sold for the balance of the mortgage.² This is important because the gain from a foreclosure of a principal residence may be eligible for the $250,000 ($500,000 for jointly-owned marital property) exclusion.
For example, for foreclosure of a nonrecourse debt,
| Nonrecourse debt | $ 500,000 |
| Tax basis (cost to determine tax gain or loss) | $ 300,000 |
| Gain | $ 200,000 |
If the holding period requirements are met and the residence was a principal residence, the above gain would be tax-free.
(Note: The above example is for consistency and contrast with the results for recourse debt. Most non-recourse debt for a residence is purchase-money debt, and would not exceed the tax basis (purchase price) of the residence. When the residence was a replacement residence for a principal residence sold before May 7, 1997, the tax basis can be less than the cost of the residence. Most of the mortgages for residences acquired in that scenario have probably been refinanced and are now recourse debt.)
For recourse debt, the debt is only satisfied up to the fair market value of the property. There is a sale up to that amount. If the lender forgives the balance of the mortgage, there is cancellation of debt income, which is taxed as ordinary income.3 (Regulations § 1.61-12.) (But see tax relief enacted for certain recourse debt secured by a principal residence, below.)
For example, for foreclosure of a recourse debt,
| Recourse debt | $ 500,000 |
| Fair market value | $ 450,000 |
| Cancellation of debt (ordinary income) | $ 50,000 |
(If the cancellation of debt was for “qualified principal residence indebtedness,” it will be excluded from taxable income. If the taxpayer still owns the home after the cancellation of debt, the excluded amount will be subtracted from the tax basis of the residence. See the section on “tax relief,“ below.)
| Fair market value | $ 450,000 |
| Tax basis | $ 300,000 |
| Gain | $ 150,000 |
Again, if the holding period requirements are met and the residence was a principal residence the above gain would be tax-free, but the cancellation of debt would generally be taxable as ordinary income, except for certain “qualified principal residence indebtedness.” See the section on “tax relief,“ below.
Tax relief enacted for recourse mortgage on principal residence debt forgiveness (expiring soon).
Congress has passed and President Bush approved H.R. 3648, the “Mortgage Forgiveness Debt Relief Act of 2007.” The legislation is effective for discharges of indebtedness on or after January 1, 2007 and before January 1, 2010. The Federal Bailout Legislation H.R. 1424, passed on October 3, 2008, extended this relief through December 31, 2012. The American Taxpayer Relief Act of 2012, HR 8 passed on January 1, 2013 extended this relief through December 31, 2013.
If Congress doesn’t take further action, this relief will expire after 2013.
Under the new law, a discharge of “qualified principal residence indebtedness” is excluded from taxable income. “Qualified principal residence indebtedness” is acquisition indebtedness secured by the principal residence of a taxpayer as defined for the deduction of residential mortgage interest, but the limit is $2,000,000 for the exclusion ($1,000,000 for the mortgage interest deduction) and $1,000,000 for married persons filing a separate return ($500,000 for the mortgage interest deduction). Also, the exclusion only applies to a mortgage secured by the principal residence of the taxpayer.
For this purpose, acquisition indebtedness is debt incurred to purchase or substantially improve the residence. When a residence is refinanced, the portion of the new mortgage exceeding the acquisition indebtedness doesn’t qualify.
The election to exclude the income from discharge of principal residence indebtedness is made on Form 982 (Re. February 2011), Part I, lines 1.e and 2. According to IRS Publication 4681, a basis reduction amount is entered at Part II, like 10.b. only if the taxpayer still owns the residence after the debt cancellation.4 IRS Publications aren’t considered legal authority and I haven’t found any other authority for not making a basis adjustment when the debt cancellation happens at the same time as a foreclosure or short sale.
The exclusion does not apply if the discharge relates to providing services to the lender or any other factor not related to a decline in the value of the residence or the financial condition of the taxpayer/borrower.
According to IRS Publication 4681, if the taxpayer continues to own the home after the debt cancellation, the tax basis of the residence (cost used to determine taxable gain or loss on sale) is reduced by any amount of discharge of indebtedness excluded from taxable income, but not below zero. The basis reduction is entered at Part II, line 10b on Form 982. There is no basis adjustment if the debt cancellation happens with a foreclosure or short sale. There will be two calculations. (1) Cancellation of debt income eligible for exclusion. (2) Sale of residence to apply the applicable exclusion.
The new exclusion of income for discharge of acquisition indebtedness for a principal residence takes precedence over the exclusion relating to insolvency (discussed below), unless the taxpayer elects otherwise.
For example, if the previous example of a foreclosure for a recourse debt was eligible for the exclusion, here are the tax results:
| Recourse debt | $ 500,000 |
| Fair market value | $ 450,000 |
| Cancellation of debt excluded from taxable income | $ 50,000 |
| Fair market value | $ 450,000 |
| Tax basis | $ 300,000 |
| Gain | $ 150,000 |
If the holding period requirements are met, the above gain would qualify for the exclusion ($500,000 married, joint or $250,000 single) for sale of a principal residence.
(Remember the foreclosure of a non-recourse mortgage is not a discharge of indebtedness, but a “sale” of the residence in satisfaction of the mortgage. Therefore, such a foreclosure won’t qualify for the new exclusion, but may qualify for the exclusion of gain for sale of a principal residence. Also, since the balance of acquisition indebtedness is almost always less than the tax basis (cost) of the residence, it would be highly unusual for there to be a gain from a foreclosure.)
Disqualified debt taxable first.
An “ordering rule” in the tax law says that the exclusion only applies to as much of the amount discharged as exceeds the amount of the loan which is not qualified principal residence indebtedness.5 The IRS explains how to apply the rule at Page 8 of Publication 4681.
For example, Julie Smith’s residence was foreclosed in 2011. The fair market value of her home was $200,000. The balance of her mortgage was $275,000. Julie had used $50,000 from refinancing her home to pay down her credit card debt, not for home improvements. $50,000 of the debt discharge that is not qualified residence debt would be taxable, and the remaining $25,000 that is qualified residence debt would be excluded from taxable income.
Another example, the residence of John and Mary Taxpayers was foreclosed in 2011. The fair market value of their home was $1,500,000. The balance of their mortgage, which was all acquisition indebtedness, was $2,250,000. Since the maximum qualified principal residence indebtedness is $2,000, 000, $250,000 of the debt was not qualified principal residence indebtedness. The $250,000 non-qualified debt cancellation would be taxable income, and the remaining $500,000 that is qualified indebtedness would be excluded from taxable income.
Amounts that are otherwise taxable in the above examples could qualify for exclusions under other exceptions, such as for insolvency or bankruptcy.
California debt cancellation tax relief for homeowners (expired December 31, 2012).
California also has enacted relief legislation for cancellation of mortgage debt relating to the acquisition of a principal residence. California hasn’t yet conformed to the federal extension of this relief for 2013.
Governor Schwartzenegger signed SB 401 (Wolk), the Conformity Act of 2010, on April 12, 2010.
Effective for taxable years 2009 through 2012, the maximum qualified principal residence indebtedness eligible for relief is $400,000 for taxpayers who file as married or registered domestic partners filing a separate return and $800,000 for taxpayers who file joint returns, single persons, heads of household and qualifying widows or widowers (other individual taxpayers). The federal limits are $1 million for married persons filing a separate income tax return or $2 million for other individual taxpayers.
The debt relief that can be excluded from taxable income is limited to $250,000 for married or registered domestic partners filing a separate return and $500,000 for other individual taxpayers. The federal exclusion is limited to the amount of qualified principal residence indebtedness.
Note that the amount that can be excluded from taxable income for California was increased compared to the amounts that could be excluded for 2007 or 2008, which was $125,000 for married or registered domestic partners filing a separate return and $250,000 for other individual taxpayers.
There is no California equivalent to Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness. Use the Federal form marked “California” at the top.
Remember the tax basis of the residence is reduced for the excluded gain.
What happens with a “short sale”?
Short sales are taxed under the same rules as foreclosures.
Recourse debt cancellation is not satisfied with the surrender of the property, so any debt not satisfied with the sale proceeds would be taxable as cancellation of debt income, except for certain “qualified principal residence indebtedness.” See section on “tax relief“ above. (Rev. Rul. 92-99, 1992-2 CB 518. Also see Treasury Regulations Section 1.1001-2(a)(2).)
Therefore, the tax consequences would be similar to the “recourse debt” example, above. The buyer and seller might also have legal concerns about whether the lender would consent to the transaction and whether (for recourse debt) the lender would in fact forgive the debt.
For example, for a recourse debt short sale,
| Net sale proceeds | $ 450,000 |
| Tax basis | $ 300,000 |
| Gain | $ 150,000 |
| Debt | $ 500,000 |
| Pay off using net sale proceeds | $ 450,000 |
| Cancellation of debt (ordinary income) | $ 50,000 |
(If the cancellation of debt was for “qualified principal residence indebtedness,” it will be excluded from taxable income and be subtracted from the tax basis of the residence. See the section on “tax relief,” above.)
For non-recourse debt short sales when the seller and buyer require the cancellation of the debt by the lender as a condition of the sale, the debt cancellation is included in the sale proceeds, like for a foreclosure.6
Therefore, a “short sale” can be a viable alternative to a foreclosure for debtors with nonrecourse debt and who qualify for the exclusion from income of the gain from the sale of a principal residence.
What about selling expenses for a recourse mortgage?
For simplicity, I have disregarded selling expenses in the above discussion. For a short sale, selling expenses reduce the sales proceeds available to reduce the loan. For a foreclosure or deed in lieu of foreclosure, selling expenses are added to the debt. (See Jerry Myers Johnson v. Commissioner, TC Memo 1999-162, affirmed CA-4, 2001-1 USTC ¶ 50,391.) The net result should be similar, assuming the fair market value of the property equals the selling price for a short sale.
For example, for foreclosure of a recourse debt,
| Recourse mortgage balance | $ 500,000 |
| Selling expenses | $ 50,000 |
| Total debt | $ 550,000 |
| Fair market value | $ 450,000 |
| Cancellation of debt (ordinary income) | $ 100,000 |
(If the cancellation of debt was for “qualified principal residence indebtedness,” it will be excluded from taxable income. According to IRS Publication 4681, if the cancellation of indebtedness happened relating to a short sale, no basis adjustment would be required. If the taxpayer still owned the home after the debt cancellation, the exclusion amount would be subtracted from the tax basis of the residence. See the section on “tax relief,” above.)
| Fair market value | $ 450,000 |
| Tax basis | – $ 300,000 |
| Selling expenses | – $ 50,000 |
| Gain | $ 100,000 |
For example, for a recourse debt short sale,
| Sales price | $ 450,000 |
| Selling expenses | – $ 50,000 |
| Tax basis | – $ 300,000 |
| Gain | $ 100,000 |
| Recourse mortgage balance | $ 500,000 |
| Pay off using net sale proceeds ($450,000 sales price – $50,000 selling expenses) |
$ 400,000 |
| Cancellation of debt (ordinary income) | $ 100,000 |
(Same caveat for “qualified principal residence indebtedness” as above.)
Other exceptions for cancellation of debt income.
Cancellation of debt income may not be taxable if the debtor is insolvent or has the debt discharged in bankruptcy.7 With recent changes in the federal bankruptcy laws, it is much harder for individuals to file bankruptcy than before the changes.
What if the fair market value of the home has dropped after purchase?
Example – Non-recourse foreclosure/short sale
| Mortgage balance | $ 500,000 |
| Tax basis | $ 700,000 |
| Loss | – $ 200,000 |
(The fair market value of the property is disregarded for a non-recourse mortgage.)
If this is a principal residence, the loss is a non-deductible personal loss.
Example – Recourse foreclosure/short sale
| Mortgage balance | $ 500,000 |
| Fair market value | $ 450,000 |
| Cancellation of debt income | $ 50,000 |
(But see the rules for exclusion for cancellation of “qualified principal residence indebtedness” in the section on “tax relief,” above.)
| Fair market value | $ 450,000 |
| Tax basis | $ 700,000 |
| Loss (for personal residence, non-deductible) | – $ 250,000 |
Considerations for rental real estate
Owners of rental properties often have accumulated suspended passive activity losses that can be applied against the income from a debt cancellation with respect to the rental.
Losses from the sale of income-producing properties may be deductible as ordinary losses under Internal Revenue Code Section 1231. (The loss is reported on Form 4797.) The loss may offset cancellation of debt income. If the property isn’t income producing, the loss may be a capital loss, limited to capital gains plus $3,000.
Taxpayers other than C corporations may elect to exclude cancellation of “qualified real property business indebtedness” from taxable income. (Internal Revenue Code Sections 108(a)(1)(D) and 108(c).) This is mostly debt incurred to acquire, construct, reconstruct or substantially improve real property used in a trade or business. The IRS Chief counsel has said that rental real estate is considered to be used in a trade or business provided the taxpayer didn’t use the property for more than 14 days in the taxable year.8 Refinanced debt up to the qualifying amount of a previous debt also qualifies. The tax basis of depreciable real property is reduced for the excluded gain. The amount excluded is limited to the adjusted basis of depreciable real property before the discharge.
Exclusions for discharges of debt in bankruptcy in a title 11 case and up to the amount of insolvency are also available for cancellations of debt relating to investment real estate.
The tax basis of assets must be reduced for the excluded gain.
(Thanks to Richard Ogg, EA, who brought the Briarpark decision to my attention!)
California liability relief for Short Sales.
California enacted SB 458, on July 11, 2011. Under this legislation, when a short sale is made of a California dwelling with not more than four units with the written consent of the holders of the deeds of trust or mortgage for the first deed of trust and junior mortgages, the lenders may not pursue the seller of the property for any deficiency on the mortgages.
In order to qualify for this relief, the seller must meet two requirements: (1) Title must be voluntarily transferred to a buyer by grant deed or by other document of conveyance that has been recorded in the county where all or part of the real property is located; and (2) The proceeds of the sale must be tendered to the mortgagee, beneficiary, or the agent of the mortgagee or beneficiary, in accordance with the parties’ agreement.
A holder of a note may not require the trustor, mortgagor or maker of the note to pay any additional compensation, aside from the proceeds of the sale, in exchange for the written consent to the sale. (The seller isn’t prohibited from offering a partial payment to a mortgage holder to get consent, but the seller must initiate the offer.)
The liability relief for short sales is superior protection compared to trust deed foreclosures for recourse mortgages. For a recourse mortgage, the anti-deficiency protection only applies to the first trust deed when that mortgage is foreclosed.
A short sale gives the property owner more control over the process than a trust deed foreclosure.
Since the lender doesn’t have to consent to the short sale and has the option of pursuing a “long form“ judicial mortgage foreclosure, including the ability to pursue deficiencies, it appears most California mortgages for residences other than for the original purchase of a principal residence will still be recourse loans. (Judicial foreclosures are very rare in California for residential real estate.)
The legislation is a two-edged sword. More lenders might not consent to short sales since they are foregoing significant legal rights.
California extends nonrecourse protection when refinancing certain mortgages.
Governor Brown approved Senate Bill 1069 on July 9, 2012. Effective January 1, 2013, a refinancing for a California dwelling for not more than four families occupied entirely or in part by the purchaser will still be nonrecourse for the portion of the loan principal refinanced that was a purchase money mortgage.
For example, Sally Smith bought a home in 2010 for $500,000, for which she borrowed $400,000 on a mortgage secured by the home. On February 1, 2013, she refinances the mortgage, with a current balance of $395,000, and replaces it with a new mortgage for $450,000. $395,000 of the new mortgage is nonrecourse, and $55,000 of the new mortgage is recourse.
“Nonrecourse” means the lender can only look to the residence for recovery of the principal in the event of default. See the section “How are foreclosures (and deeds in lieu of foreclosure) taxed?” about the tax consequences of a foreclosure or short sale with a non-recourse mortgage.
It’s unclear whether the new rule will apply for subsequent refinancings or can only be applied once.
We recommend that you always consult with a real estate attorney when planning a short sale or foreclosure. You also might want to consult with an attorney about whether refinancing will be recourse or nonrecourse.
The legal rules for short sales and foreclosures are complex. You should always consult with a real estate attorney for a short sale or foreclosure.
For more information, there are explanations about foreclosures and cancellation of debt in IRS Publications 4681, Canceled Debts, Foreclosures, Repossessions and Abandonments, 523, Selling Your Home; 552, Taxable and Nontaxable Income; and 544, Sales and Other Dispositions of Assets at www.irs.gov.
P.P.S. For more information, watch Michael Gray’s Financial Insider Weekly, interviews of attorney and CPA Scott Haislett, “California Short Sales and Foreclosures”, and attorney William Mahan, “How Mortgage Modifications, Short Sales and Foreclosures Work” and “Short Sales and Foreclosures – Tax Consequences”. Attorney Michael Malter of Binder & Malter, LLP also discusses short sales in Michael Gray’s interview for Financial Insider Weekly, “What you should know about bankruptcy for individuals”.
There are also explanations about foreclosures and cancellation of debt in IRS Publications 523, Selling Your Home; 552, Taxable and Nontaxable Income; and 544, Sales and Other Dispositions of Assets at www.irs.gov. Also see the instructions for Form 982. The IRS also recently issued IRS Publication 4681, Canceled Debts, Foreclosures, Repossessions and Abandonments.
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