Tax & Business Insights

When is Debt Cancelled?

Volume 23 Issue 4 -- July/August 2011

While most practitioners know that the cancellation or forgiveness of debt can trigger recognition of taxable income, in many cases it is unclear exactly when that takes place.

Clearly, if there is a formal agreement from a lender agreeing not to sue for the balance due on a loan, that will create income from the forgiveness of debt. In other situations, such as many mortgage foreclosures, however, the situation may be far less clear-cut.

Suppose that when Richie Beyer bought his dream house on Happiness Lane he signed a mortgage or deed of trust as well as a promissory note. The mortgage or deed of trust creates the lender’s secured interest in the property, while the promissory note is Richie’s personal promise to repay the amount of the loan. After the value of the property rose, Richie took out a home equity line of credit that he used to buy a fancy new car. Three years later, Richie’s business went bust and soon thereafter he defaulted on the mortgages.

There are a number of ways that Richie’s situation could be resolved. He might enter into a short sale hoping to recover most of the unpaid balance of the mortgage; or, Richie might simply walk away from the property or turn it over the to creditor; or the lender might foreclose on the property.

From a tax standpoint, each of these alternatives can raise different timing issues. A short sale, even with the lender’s approval, usually will not discharge Richie’s debt, unless the lender specifically agrees to waive any deficiency. 

Suppose Richie walks away from the property or the lender forecloses. The lender should send Richie a 1099-A. The function and effect of both Form 1099-A and the related Form 1099-C were discussed in an earlier newsletter titled  Understanding “Under Water.

Has Richie been discharged from any debt? By walking away from the property, Richie will not walk away from his personal liability on the purchase money note, except in a few states that bar lenders from obtaining judgments against borrowers for most deficiencies.

If Richie lives in one of those few states that preclude deficiency judgments against borrowers like Richie, his obligation may effectively be treated as non-recourse for tax purposes. If there is no possible liability for a deficiency, then there may not be any discharge of debt income.

In other states, the ability of lenders to obtain a deficiency may depend upon either the nature of the property, the nature of the loan, or other factors. For example, in a few states, a purchase money loan may not give the lender a right to a deficiency, but other lenders may obtain them. If Richie lived in one of those states, the lender on the first mortgage may not be able to get a 

deficiency judgment, but the lender on the home equity line of credit may.

In most states, however, Richie’s entire debt will be “recourse” and any satisfaction of that debt other than by repaying the full amount of the debt will be income from the discharge of debt. The question here is when does that occur?

If there is no clear agreement with a lender concerning the discharge of a debt, the tax law says that income from the debt discharge will occur when it is clear from the facts that the debt will never be repaid. This may depend upon a variety of facts and circumstances.

Some states limit the ability of lenders to obtain deficiency judgments. For example, in a few states, a lender may have to choose between recovering the property and seeking a deficiency judgment. In such states, foreclosure may trigger cancellation of the debt for tax purposes.

In other states, a lender may have to foreclose a certain way or take other action to protect the right to a deficiency judgment. If the lender fails to do that, it may trigger discharge of the debt for tax purposes.

Even in states where a deficiency judgment is possible, other actions by the lender may indicate that the  debt is treated as cancelled for tax purposes. For example, if the creditor writes off the debt as uncollectible, that may indicate that the debt will be treated as discharged for tax purposes.

In most states, where the lender can obtain a deficiency judgment, the lender will have until the expiration of the statute of limitations to bring a suit to enforce the debt. Thus, the lender may have at least 3 to 5 years or as much as 10 years to wait to see if a borrower’s financial situation improves before deciding to bring an action to enforce a mortgage debt. Hence the amount and timing of any debt discharge may not be clear for years after a foreclosure.

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

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