Volume 21 Issue 1 -- January/February 2009
Prior to the recent downturn in
Let’s assume that Ms. Ena
Hole purchased a home as her principal residence. Today, the mortgage debt
balance is $400,000, while the home is worth only about $300,000.
Unfortunately, Ena was unable to continue making the mortgage payments
and lost the home in foreclosure. At
the time of the foreclosure, the bank took over the property, sold it at a
foreclosure sale for $325,000, and issued Ena a Form 1099-C reflecting that
$75,000 of mortgage debt had been forgiven.
An old concept of taxation is
that if a debt is partially or totally forgiven, the amount of debt forgiven is
generally taxable income to the person receiving the forgiveness — in
this case, Ena. Normally, unless she
were insolvent or in bankruptcy, the amount of the income forgiveness would be
taxable to Ena, and she would have to include that amount on her tax return as
The concept of income from
forgiveness of indebtedness is foreign to many taxpayers who feel that, after
losing money on the transaction, having to pay tax on the amount forgiven seems
like adding salt to the wounds of bad luck. As a result, many taxpayers find the
concept of income from forgiveness of debt difficult to fathom.
In 2007, Congress amended § 108
of the Internal Revenue Code (IRC) to prevent the situation of what is now
referred to as a “short sale” of a principal residence from creating taxable
income to the seller. This change applies through 2013.
Sometimes in this newsletter we
have used the term “home,” but the new law applies only to a “principal
residence.” Not only is the new law limited to “principal residences,” but
it also applies only to debt used to acquire or improve such residences. If Ena
had refinanced her original mortgage or taken out a second mortgage or home
equity line of credit and used the
extra proceeds to purchase a car or pay off credit card debt, that
non-acquisition debt will not be covered by the new law. Any forgiveness of that
debt will be taxable under the prior rules, unless Ena is insolvent or in
Real estate lending practices
vary throughout the country, but in many states foreclosure of a home does not,
by itself, discharge the debt due to the mortgage lender. In other words, even
after the foreclosure, the borrower may be liable for the difference between the
amount of the mortgage balance and the amount received by the lender (the bank).
This could result in what is often called a “deficiency judgment.”
In such cases, there is no “income from forgiveness of debt” so long
as there is a possible deficiency judgment.
One cost for the new law’s tax
benefit is that there is a reduction in tax attributes, in this case the basis
in the home. The new law requires that any debt forgiveness that is excluded
from income must be used to reduce the taxpayer’s basis — the cost — in
the home for income tax purposes. This also requires the filing of a special
form, Form 982, to report the exclusion of the debt forgiveness income and any
The application of the required
basis reduction in cases of debt forgiveness without foreclosure seems
relatively straightforward, but how the basis reduction will work when the
taxpayer loses the home through foreclosure is not yet clear.
This basis reduction could also
have effects when a home is eventually sold. IRC § 121 allows a couple to
escape income tax on up to $500,000 of gain on the sale of a principal
residence. If the cost basis in the home is reduced as a result of debt
forgiveness, then there is an increased chance that a subsequent sale of the
home, perhaps when the market recovers, could generate taxable gain.
As noted above, the new law
applies only to “principal residences.” It has no application if other
property, such as rental property or property bought for speculation, is sold
short or lost in foreclosure.
Many homeowners incorrectly
believe that because they have lost money on the sale of their home they should
be able to claim a loss on their tax return.
The sale of a home that was earlier converted to rental use can, in some
situations, result in a business loss. But Ena will not get a loss on the sale
of her home, no matter how far Ena goes “in a hole.”
If you or a client have
questions related to this topic, keep The Tax and Business Professionals in
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