Tax & Business Insights

Understanding “Under Water”?

Volume 22 Issue 3 --  May/June 2010

Phrases like “under water” and “short sale” have taken on new meanings in recent years. There was a time when short sales applied only to the sales of securities, but it is very common now for tax professionals to have clients faced with the choice of having to sell properties or walk away from them for less than the purchase price -- and often for less than the mortgage balance.

Let’s assume that Don D. Tern (DDT) bought a house on Morbid Lane for $600,000. DDT signed a mortgage or deed of trust as well as a promissory note for that amount. The mortgage or deed of trust creates the lender’s secured interest in the property, while the promissory note is DDT’s personal promise to repay the amount of the loan. Three years after buying the house, DDT was laid off. As a result, he could not afford the mortgage payments and had little or no equity in the property.

By the time most clients like DDT reach the office of a tax professional, they have already done something about the mortgage. They may have simply abandoned or walked away from the property; they may have formally given it back to the lender or the lender may have foreclosed; or they may have filed for bankruptcy. Often they will not have received tax advice before taking one of these steps. After the fact, what is the tax professional to do?

For DDT there are two principal tax issues — gain or loss on the disposition of the property and potential discharge of indebtedness income (“DOI income”).

If DDT abandoned or walked away from the property or turned it over to the lender (perhaps with a deed in lieu of foreclosure), DDT has effectively disposed of the property. The IRS insists that gain or loss be computed on that disposition as the difference between the fair market value of the property and the adjusted basis in the property.

Most lenders, in that situation, will send DDT a Form 1099-A which will report, among other things, the date the lender recovered possession (or the date of abandonment), along with the outstanding debt balance, the fair market value of the property, and whether DDT was personally liable for repaying the debt. The 1099-A does not report the amount of DOI income!

In situations where there is an abandonment or foreclosure and forgiveness of debt in the same year, the lender may send only a 1099-C which does list the amount of any debt discharged. More commonly, a 1099-A will be sent in one year and a 1099-C may follow in a later period. Why?

Except in some states that have either anti-deficiency statutes or one-action statutes, the lender’s retaking of possession or conducting either a public or private sale of the property does not preclude the lender from later suing the borrower for any debt remaining unpaid after the sale — called a “deficiency.” The same is true in most cases following a short sale — which is a sale at a loss with the lender’s consent. Unless the lender has waived the right to recover a deficiency, a short sale will not affect DDT’s liability for any deficiency.

In some states, lenders may not have the option of suing for a deficiency on certain types of mortgage loans. If there is no liability for a deficiency, then there may not be any DOI income. There may be some question about the tax consequences if the mortgage documents obligate the borrower to pay the full amount of the loan but state law prevents the lender from bringing a deficiency action.

In the majority of states, where the lender can sue borrowers like DDT for a deficiency after an abandonment or foreclosure, the lender has until the expiration of the statute of limitations on a suit to enforce the promissory note to make a decision about forgiving the remaining debt. In most states, where the lender will have at least 3 to 5 years to bring an action to enforce the debt, the amount of any DOI income may not be clear for years.

It is not until the mortgage debt is actually forgiven that a 1099-C is required. That is also the point at which the borrower, DDT here, will need to report the DOI income on Form 982. Arguably, if the lender never brings a deficiency judgment action, the debt is “forgiven” only when the statute of limitations expires. In some cases, it appears that some lenders may not be issuing the 1099-A’s or 1099-C’s as required. DOI income relating to a principal residence may be excludable from income in some situations. See Tax Aspects of Short Sales of Homes.

 If a borrower goes through a bankruptcy, it is important to determine precisely what debts were discharged. While DOI income in bankruptcy need not be recognized, it is important to report the debt discharge on Form 982 along with any required reductions in other tax attributes.

If you have questions about the tax consequences of underwater mortgages, please contact the Tax & Business Professionals.

Copyright 2010
By Tax and Business Professionals, Inc.
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