Tag Archives: mortgage forgiveness debt relief act

Tax Consequences

Understanding The Tax Consequences Of The Mortgage Forgiveness Debt Relief Act

Over the past couple of weeks there have been numerous news stories, both local and national, citing real estate experts who suggest that if homeowners don’t sell this year, they could face big tax consequences because the Mortgage Forgiveness Debt Relief Act (MFDRA) will expire.

If you are not familiar, the MFDRA was first enacted by Congress in 2007 and it is set to expire this year. Generally, the MFDRA allows exclusion of income realized as a result of modification of the terms of the mortgage, or foreclosure on your principal residence. It essentially allows taxpayers to exclude income from the discharge of debt on their principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief.

But the reality is, for many Arizonans, the MFDRA has very little impact because most first mortgages are “non-recourse” loans and most seconds don’t qualify for the tax protection of the MFDRA; therefore, no matter when we sell our homes, we will not be taxed, whether it is in 2012 or 2013, irrespective of whether the MFDRA gets extended.

The IRS website lays this out for us: “a non-recourse loan is a loan for which the lender’s only remedy in case of default is to repossess the property being financed or used as collateral. That is, the lender cannot pursue you personally in case of default. Forgiveness of a non-recourse loan resulting from a foreclosure does not result in cancellation of debt income.”

And, here’s the problem: whether it’s because inventories are at historic lows in the Phoenix market, or simply a tactic to get underwater homeowners to sell their homes, realtors are claiming that failure to sell an underwater home this year will result in huge tax consequences next year after the MFDRA expires.

These real estate “experts” are clearly giving self-serving information to homeowners and the media hoping to convince homeowners that they must sell this year. These realtors who tell homeowners to sell this year because MFDRA will expire are giving “tax” advice in an attempt to scare homeowners into selling their homes now. But, several of the form documents realtors use here in Arizona, force both buyer and seller to affirmatively waive any claims you have against them for both financial, legal and tax advice. So, when homeowners learn they have been duped, they have no legal recourse.

The bottom line is, you need to know what your legal rights are. Before making important financial, legal and tax decisions, make sure to speak to someone who is willing to stand behind the counsel they give you so that you can make these important decisions using accurate information.

For more information as to how Robert has helped hundreds of homeowners in Phoenix with understanding tax consequences and more, visit naglelawgroup.com or call (602) 595-3156.

Short Sale - AZ Business Magazine January/February 2012

The Tax Implications From A Short Sale, Foreclosure

The truth of consequences: There can be tax implications from a short sale and foreclosure


The only sure things in life are death and taxes.

And like death, taxes can sometimes sneak up and surprise you. Some homeowners who have faced foreclosure or a short sale might be startled to learn that they may face tax penalties. And many won’t find out that they owe taxes until they open their mail and find a 1099.

“What most owners of residential homes being foreclosed upon or short selling do not realize is how uncertain, complicated and confusing the federal and state income tax rules are that apply to their situation,” says Eliot Kaplan, a partner with Squire Sanders in Phoenix.

So how is it possible that you can lose your home and still owe money?

“Cancellation of debt (COD)  is the term tax professionals use to describe the kind of income that arises for tax purposes when debt is cancelled or forgiven for less than its full face or principal amount,” says Kelly C. Mooney, a shareholder with the law firm of Gallagher & Kennedy in Phoenix. “COD income is specifically included in a taxpayer’s gross income … COD income is always treated as ‘ordinary’ income for federal tax purposes, such that the tax rates applicable to ordinary income — which can be as high as 35 percent for individuals — apply to COD income.”

Thankfully, all upside-down homeowners won’t face tax implications. Under the Debt Forgiveness Act of 2007, any debt forgiven on a loan used to purchase a principal residence is not taxable income. But if you took out a second mortgage, you might be in tax trouble.

For federal income tax purposes, a short sale or a foreclosure — whether via a judicial foreclosure or a trustee’s sale — can trigger income tax consequences, depending on whether the debt at issue is “recourse” or “nonrecourse” for federal tax purposes, says Mooney.

If your mortgage is non-recourse, your lender can’t make you pay the loan. The only thing it can do is foreclose and sell your house for payment on the debt. If the borrower defaults, the lender can seize the collateral, but the lender’s recovery is limited to the collateral.

“If the debt was nonrecourse, meaning the lender had no recourse other than to take the home back, the debt forgiveness is not taxable,” says Dale A. Walters, CPA, Keats, Connnelly and Associates in Phoenix. “However, there will be a reportable gain to the homeowner if the sales price of the home is greater than the mortgage. Many states allow you to walk away from your (no-recourse) mortgage because of anti-deficiency statutes that prohibit lenders from seeking judgments.”

States that have anti-deficiency laws are Arizona, Alaska, California, Connecticut, Florida, Idaho, Minnesota, North Carolina, North Dakota, Texas, Utah, and Washington.

Where homeowners get into tax trouble is if they are facing a foreclosure or short sale and they have taken out a second mortgage or line of credit against their home.

“All second mortgages and lines of credit are recourse loans,” Walters says.

With a recourse loan, you’re personally responsible for repaying the bank or mortgage company. If you don’t repay the loan, or default, the bank can sue you for the remaining amount due on your loan if the proceeds from a foreclosure or short sale don’t cover the amount you owe. While mortgages are typically nonrecourse debt, a foreclosure can trigger the loan to become recourse debt at the request of the lending institution.

“The difference between a ‘recourse’ loan or a ‘nonrecourse’ loan under state law is whether the lender has the right to collect the deficiency,” Kaplan says.

And what about the tax implications?

Kaplan explains using this example: A homeowner purchased a residential home in 2007 for $1 million, used $100,000 cash as a downpayment, took out an interest-only recourse loan of $900,000 that was secured by the residential home, and used the home as his or her personal residence. In 2011, when the residential home had a fair market value of $700,000, the owner voluntarily gave back the home to the lender.

“Using the foreclosure and short sale facts above, if the lender decides as part of the foreclosure or the short sale to forgive the deficiency, the owner will have taxable ordinary income equal to the $200,000 deficiency,” Kaplan says.

“Fortunately, until January 1, 2013, the U.S. and Arizona have provided for relief from having to include the lender forgiveness of the $200,000 deficiency described in the above foreclosure or short sale as taxable income,” Kaplan says.

So how do you know if you’re going to face the tax man after a short sale or foreclosure?
“The best way to know is to ask your tax advisor,” says Lawrence Warfield of Warfield & Company, CPAs in Scottsdale. “The tax from some debt forgiveness can be avoided, but the facts and circumstances of each depend on various scenarios and issues.”

Understanding the terms: Foreclosure and Short Sale

Foreclosure: When a lender acquires ownership of the residential home securing its loan either through the owner of the residential home voluntarily transferring the residential home to lender or through the lender exercising its state law foreclosure rights.

Short sale: When the lender permits an owner of a residential home which secures its loan to sell such residential home for less than what is owed to the lender under the loan. Usually, the lender receives all the proceeds from such sale.


5 questions to ask

Here are some helpful questions that you will need to ask you tax professional:

1. Can I avoid paying taxes on the forgiven debt if I was insolvent at the time of the short sale?
2. Do I have to file bankruptcy to be considered insolvent?
3. If you already went through a short sale and paid taxes can you file an amended return and get a refund?
4. Does a IRS Form 982 have to be filed in order to be eligible for tax relief?
5. Am I protected under the Mortgage Forgiveness Debt Relief Act Of 2007?


Mortgage Forgiveness Debt Relief Act (MFDRA)

Generally, the MFDRA lets you exclude from your taxable income most if not all of any cancelled or forgiven debt that might come about because of a foreclosure. There are limits, however:

1. The cancelled debt has to be on your principal residence. The debt can be from a loan that you took out to buy, build or substantially improve your home. It can also be for refinancing the mortgage on your home. Since it applies only to your principal residence, commercial and vacation properties usually don’t qualify.
2. Only debt that’s forgiven in 2007 through 2012 qualifies.
3. If you file a joint tax return with your spouse, you can exclude up to $2 million of forgiven debt from your income. If you’re married and file separately, you can exclude up to $1 million.
4. You have to report the amount of forgiven debt on a special IRS form, and attach it to your tax return.

Arizona Business Magazine January/February 2012

Income Tax Traps

Short Sales And Foreclosures: Income Tax Traps For The Unwary Homeowner

Short Sales and Foreclosures: Income Tax Traps for the Unwary Homeowner

by Stuart Pack, J.D. and Kelly C. Mooney, J.D., L.L.M.

When considering a short sale, foreclosure or other strategic default under the terms of a mortgage or deed of trust, most homeowners and many professionals focus on the immediate concern of whether the transaction will result in personal liability for any debt deficiency resulting from the short sale or foreclosure.

However, the income tax consequences of a short sale or foreclosure should also be given serious consideration, as, in many cases, the possibility of negative income tax consequences could outweigh any potential benefits of a decision to short sell or walk away from the property.

For federal income tax purposes, a short sale of real property or a foreclosure upon real property (whether via a judicial foreclosure or a trustee’s sale) can trigger two distinct types of income tax consequences, depending on whether the debt at issue is “recourse” or “non-recourse” for federal tax purposes. These income tax consequences and the differences between recourse and non-recourse debt are discussed below.

1. Tax Consequences of a Short Sale or Foreclosure With Respect to Recourse Debt

If the debt in question is recourse debt for federal tax purposes, any short sale or foreclosure that involves the forgiveness or cancellation of all or a portion of the debt typically triggers the recognition of (a) cancellation of indebtedness (“COD”) income to extent that the amount of the forgiven debt exceeds the fair market value of the foreclosed upon or short sold property; and (b) gain or loss from a “deemed” sale or exchange of the foreclosed upon or short sold property (i.e., the taxpayer is treated as though he or she sold the property for federal income tax purposes). Consequently, the federal income tax consequences of a short sale or foreclosure with respect to recourse debt are bifurcated between the recognition of COD income on the one hand and the recognition of gain or loss on a deemed sale or exchange of the property on the other.

(a) The COD Income Component

COD income is the term tax professionals use to describe the kind of income that arises for tax purposes when debt is cancelled or forgiven for less than its full face or principal amount.  COD income is specifically included in a taxpayer’s gross income under Section 61(a)(12) of the Internal Revenue Code.  Importantly, COD income is always treated as “ordinary” income for federal tax purposes, such that the tax rates applicable to ordinary income (which can be as high as 35% for individuals) apply to COD income.

(b) The Sale or Exchange Component

Like any sale or exchange of real property, the “deemed” sale or exchange of the short sold or foreclosed upon property that occurs upon the cancellation of recourse debt can trigger the recognition of gain or loss.  The amount of gain or loss is determined by comparing the fair market value of the property at the time of the short sale or foreclosure to the taxpayer’s adjusted tax basis in the property.

Most often, due to the current economic situation, short sales or foreclosures result in a loss because the taxpayer’s basis in the property exceeds the property’s fair market value.  In the event that the taxpayer held the property as a capital asset for a sufficient period of time, the gain or loss recognized on the deemed sale will be treated as capital gain or capital loss for federal income tax purposes.

While the recognition of capital gain can be beneficial, due to the lower (i.e., 15%) tax rate on capital gain, the recognition of capital loss may not be as helpful.  In general, capital losses can only be used to offset capital gain and cannot be used to offset ordinary income (like COD income), although individuals can use up to $3,000 in capital losses each year to offset ordinary income.

2. Tax Consequences of a Short Sale or Foreclosure With Respect to Non-Recourse Debt

If the debt in question is non-recourse debt, any short sale or foreclosure that involves the forgiveness or cancellation of all of a portion of the debt will only trigger the recognition of gain or loss on a “deemed” sale or exchange of property.  The forgiveness of non-recourse debt, in cases involving a short sale or foreclosure on real property, does not trigger the recognition of COD income.  In cases involving non-recourse debt, the amount of the gain or loss is determined by comparing the outstanding amount of the debt to the taxpayer’s adjusted tax basis in the property.  Again, the character of the gain or loss depends on whether the taxpayer held the property as a capital asset.

3. Distinguishing Recourse from Non-Recourse Debt

Often, the most difficult component in determining the likely tax consequences of a short sale or foreclosure is ascertaining whether the debt at issue is recourse or non-recourse for federal tax purposes.  In essence, “recourse” debt is debt for which the borrower is personally liable and “non-recourse” debt is debt for which the borrower is not personally liable, but which is usually secured by other assets, such as real estate.  That being said, a number of factors go into determining whether a particular debt is recourse or non-recourse, such as the language of the debt instrument, the applicability of any State anti-deficiency statutes (for example, Arizona’s anti-deficiency statutes may be viewed as turning an otherwise recourse debt into a non-recourse debt in cases in which the debt is purchase money and the other statutory requirements are satisfied), and, in some cases, the manner in which the debt is foreclosed upon.  Given the complexities that can arise, it is recommended that a tax or real estate professional be contacted for appropriate advice.

4. Exceptions and Exclusions

In cases in which a foreclosure or short sale is likely to trigger the recognition of taxable income, whether the income is COD income or capital gain, all may not be lost.  The Internal Revenue Code provides a number of exceptions and exclusions to the recognition of these types of income, one or more of which might apply.  Again, in cases in which the recognition of COD income is likely, a tax professional should be consulted to determine if any exceptions or exclusions are likely to apply.

(a) COD Income

Section 108 of the Internal Revenue Code provides a number of exclusions and exceptions to the recognition of COD income.  In cases involving a short sale or foreclosure, the most commonly applicable exclusions include:

i. Mortgage Forgiveness Debt Relief Act

Codified as Section 108(a)(1)(E) of the Internal Revenue Code, this Act enables taxpayers to exclude up to $2 Million of COD income, so long as the cancelled debt was secured by the taxpayer’s principal residence and was incurred in the purchase, construction, or substantial improvement of the principal residence.  However, this exclusion is only in effect through December 31, 2012.

ii. Insolvency

When a taxpayer is “insolvent” for federal income tax purposes immediately before the event triggering the recognition of COD income, the COD income can be excluded from federal income tax to the extent of the taxpayer’s insolvency.

iii. Bankruptcy

If a bankruptcy petition is filed prior to the short sale or foreclosure, the taxpayer will not be required to recognize COD income by reason of the discharge.  However, if the bankruptcy petition is filed after the short sale or foreclosure then, unless some other exclusion applies, COD income would be recognized.

(b) Capital Gain

Under Section 121 of the Internal Revenue Code, any capital gain recognized on a “deemed” sale or exchange of a principal residence can be excluded from taxable income to the extent of $500,000 for married persons filing joint tax returns or $250,000 for unmarried persons.

Example
Taxpayer (T), a confirmed bachelor, buys a one family house in 1990 for $100,000 and finances it, in part, with a $50,000, 15-year mortgage loan.  In 2005, immediately after the mortgage loan is paid off in full, T decides to take advantage of the skyrocketing increase in real estate prices by taking out a new interest only mortgage loan in the amount of $300,000.  As part of the mortgage process, T’s house was appraised by his mortgage lender at $400,000.  T uses $250,000 of the new mortgage loan to buy a vintage DeLorean automobile and pay off his credit card debt and uses the other $50,000 to substantially improve the house.  In 2010, T comes to the unhappy realization that the fair market value of his house has plummeted to $200,000 and decides to short-sale the house.  T finds a buyer for $200,000 and T’s lender agrees to accept the $200,000 short sale proceeds to release the house from the lender’s deed of trust (and, in writing, the lender also agrees to release T from personal liability for the $100,000 deficiency).  What are the likely federal income tax consequences to T?

1. Capital Gain from the “Deemed” Sale of House

Since T bought the house in 1990 for $100,000 and made $50,000 of substantial improvements to the house, T’s adjusted tax basis in the house is $150,000.  Since T was deemed to have sold the house as part of the short sale in 2010 for $200,000, T will recognize $50,000 of capital gain (even thought T’s lender and not T, will receive all of the proceeds from the short sale).  If the house is T’s primary residence and other requirements of Internal Revenue Code Section 121 are satisfied, the $50,000 capital gain can be excluded from T’s taxable income because of the $250,000 exclusion right.  If the house was not T’s primary residence, then the $250,000 exclusion does not apply and T will be required to recognize the $50,000 of capital gain.

2. Cancellation of Debt Income

Assuming the new mortgage loan is recourse debt for federal tax purposes (because the debt is non-purchase money, the debt may not be treated as non-recourse under an applicable anti-deficiency statute in the case of a short sale), T would also recognize $100,000 of COD income.  If the house was T’s primary residence, then the Mortgage Forgiveness Debt Relief Act would enable T to exclude up to $50,000 of the $100,000 of COD income (because $50,000 of the $300,000 loan was used to substantially improve the house, it would be considered “qualified principal residence indebtedness”).  However, because the other $50,000 of the $100,000 deficiency was used to purchase the DeLorean and pay off T’s credit card debt, the other $50,000 would be taxable as ordinary COD income, unless T can establish he was insolvent at the time of the short sale or one of the other exclusions to the recognition of COD income applies.  If the house was not T’s primary residence, then the Mortgage Forgiveness Debt Relief Act would not apply and the entire $100,000 deficiency would be treated as taxable COD income, unless T can establish he was insolvent at the time of the short sale or one of the other exclusions to the recognition of COD income applies.

Of course, as each individual homeowner’s situation may vary, it is vital in considering any short sale or foreclosure to discuss your individual income tax situation with a tax professional.

For more information about income tax traps:

Stuart Pack, J.D. is a partner with the law firm of Nagle Law Group, P.C. in Scottsdale, Ariz. He concentrates his practice in the area of commercial and residential real estate law. He can be reached at Stuart.Pack@naglelaw.com or 602-595-6951 (x122).

Kelly C. Mooney, J.D., L.L.M. (Taxation) is a shareholder with the law firm of Gallagher & Kennedy, P.A. in Phoenix, Ariz. She practices in the area of federal tax law, with an emphasis on the taxation of individuals, corporations, partnerships, tax-exempt entities, and civil tax controversy matters. She can be reached at kcm@gknet.com or 602-530-8075.