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.
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.
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.
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 email@example.com or 602-530-8075.