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.
While designed to be accurate, this publication is not intended to constitute the rendering of legal, accounting, or other professional services or to serve as a substitute for such services.
Redistribution or other commercial use of the material contained in Tax & Business Insights is expressly prohibited without the written permission of Tax and Business Professionals, Inc.
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