Given the poor state of the economy and the plague of foreclosures presently occurring, a discussion of the tax implications of a creditor forgiving debt is necessary before a decision can be made regarding allowing a foreclosure to occur or undertaking a short sale. In addition, the discussion of the tax implication of cancelled debt is similarly important before a decision to settle a significant amount of debt or to file a bankruptcy case is made.
If you are facing a foreclosure or are considering any or some of the foregoing financial moves and thought about perhaps filing a bankruptcy case, the timing of the filing of the bankruptcy petition can be critical. Failure to consider the tax consequences flowing from forgiven debt or debt cancellation can result in tax liabilities that you were not expecting and perhaps were avoidable.
The bottom has fallen out of the housing market. Questionable lending practices in the past have left people with real estate that is worth less than what is owed on it. People have lost jobs or in many cases, folks still working have lost a significant portion of their income. With the drop in income, many property owners cannot make their mortgage payments, nor can they sell their properties unless they make up the difference between the sale price and what is owed. Most property owners simply cannot come up with the necessary money to make up the short fall between sale price and mortgage balance owing.
If an “up-side-down” property is foreclosed upon by the secured creditor and the foreclosure sale results in less than full payment of the debt or the secured creditor accepts less than full payment on their debt, most institutional creditors are required to report the shortage between what was owed and what was received to the Internal Revenue Service. (Some states bar collection of a deficiency balance from the borrower when a deed of trust is foreclosed non-judicially. If the foreclosure sale results in a deficiency, the consequence is debt cancellation which may result in a tax liability from this “additional income.”)
Taxpayers are notified that one of their creditors has reported potential income from debt forgiveness to the IRS when they receive a copy of the 1099 information reporting return that the creditor has filed with the IRS. The taxpayer, to address the forgiven debt, must file form 982 with their tax return. The creditor must report a forgiven debt transaction to the Internal Revenue Service on either a 1099-A or a 1099-C form, depending on the type of transaction. For instance, the settling of credit card debt that is not disputed, for less than what is owed, will require the creditor submit a 1099-C form if the amount “forgiven” by the creditor was more than $600.00. If you have fallen behind in paying your credit card debt, it is likely you may have received an offer from your credit card creditor to settle the debt in full for a single payment of an amount substantially discounted from what you owe. If you accept the offer and make the required payment and the amount of the discount (forgiven debt) is more than $600.00, you will likely get a 1099-C form in the mail in January and will be required to file form 982 Reduction of Tax Attributes with your next tax returns. If the transaction involving forgiven debt included a secured property, you will receive a form 1099-A from the lender.
The federal statute that sets forth which types of creditor entities are required to report for given debt is 26 U.S.C. § 6050P(c). In general, any entity in which lending money or extending credit is a significant part of their business is required to report cancelled debt.
Cancelled or forgiven debt is expressly included as part of a taxpayer’s income by 26 U.S.C. § 61(a)(12). “All income from whatever source derived” is the Internal Revenue Code’s definition of gross income.
EXCEPTIONS TO THE RULE THAT FORGIVEN DEBT IS INCOME
Mortgage Companies, Banks, Credit Unions, Credit Card Companies and other creditors are required to notify the IRS when debts are forgiven. The sophisticated electronic world we now live in allows the IRS to monitor many of the types of transactions that impact consumers. As a result, taxpayers being notified by the IRS that their tax returns were deficient some one or two years after having been foreclosed upon or after having undertaken a short sale or after having settled and paid credit card debt through a credit counseling service, only adds additional financial injury.
The Mortgage Forgiveness Debt Relief Act of 2007 is another exception created by Congress. It was enacted after the questionable practices of subprime lenders brought about the subprime loan crisis that sparked the current foreclosure epidemic that has subjected homeowners to the loss of their homes to foreclosure and after that catastrophe, a subsequent tax liability to the IRS and in many cases the State, after the foreclosure sale. The Mortgage Forgiveness legislation exempts from taxable income, cancellation of debt up to $2,000,000.00 on a qualifying personal residence. Yes, “qualifying” personal residence, see 26 U.S.C. § 163(h)(4)(a) for a definition of “Qualified Residence.”
(A) Qualified residence
(i) In general The term “qualified residence” means—
(I) the principal residence (within the meaning of section 121) of the taxpayer, and
(II) 1 other residence of the taxpayer which is selected by the taxpayer for purposes of this subsection for the taxable year and which is used by the taxpayer as a residence (within the meaning of section 280A (d)(1)).
(ii) Married individuals filing separate returns If a married couple does not file a joint return for the taxable year—
(I) such couple shall be treated as 1 taxpayer for purposes of clause (i), and
(II) each individual shall be entitled to take into account 1 residence unless both individuals consent in writing to 1 individual taking into account the principal residence and 1 other residence.
(iii) Residence not rented For purposes of clause (i)(II), notwithstanding section 280A (d)(1), if the taxpayer does not rent a dwelling unit at any time during a taxable year, such unit may be treated as a residence for such taxable year.
Note that the relief provided by the Act is temporary, including cancellation of debt from December 31, 2006 until January 1, 2013 (unless it’s extended, again). Be aware that State tax schemes may differ. States that have their state income tax follow or incorporate federal tax law accept this exemption. Other states may have enacted their own similar legislation dealing with forgiven debt.
The exemption under the federal statute for forgiven or cancelled debt on a personal residence is limited to “acquisition indebtedness.” Acquisition Indebtedness is defined by 26 U.S.C. § 163(h)(3)(B).
(B) Acquisition indebtedness
(i) In general The term “acquisition indebtedness” means any indebtedness which—
(I) is incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer, and
(II) is secured by such residence. Such term also includes any indebtedness secured by such residence resulting from the refinancing of indebtedness meeting the requirements of the preceding sentence (or this sentence); but only to the extent the amount of the indebtedness resulting from such refinancing does not exceed the amount of the refinanced indebtedness.
(ii) $1,000,000 limitation The aggregate amount treated as acquisition indebtedness for any period shall not exceed $1,000,000 ($500,000 in the case of a married individual filing a separate return).
What this means is that if the homeowner refinanced and used the proceeds of the refinancing for a purpose other than making substantial improvements on the house or paying off a loan incurred to build, buy or to make substantial improvements in the home, the forgiven refinanced debt is not exempted from being taxed as income. Thus the part of a forgiven home loan that was used to pay off a non-qualifying debt will not be exempted but will be taxed as income. Unless the resulting income can be excluded for some other reason, the result may be a tax liability.
In my own practice, I have encountered many clients who refinanced the existing loan on their personal residence to obtain funds to pay down credit card debt, pay off car loans, pay medical expenses, pay off student loans and other non-housing related personal expenses. If the proceeds of one of these home equity loans were used for non-housing related purposes, and the loan were to be discharged without full payment due to a short sale or foreclosure, additional income would have to be reported by the borrower when their tax returns for the year in which the discharge occurred are prepared. If the homeowner used loan proceeds for a purpose other than the purchase or improvement of their personal residence, the Mortgage Forgiveness Debt Relief Act of 2007 will provide no relief. Forgiven debt associated with the part of a loan that does not fall under the statutory definition of “acquisition indebtedness” is not covered by the Act.
Saving the best for last – the Bankruptcy Exemption, the most frequently used of the exclusions to exclude income flowing from forgiven debt. Cancelled or forgiven debt that would be treated as income is exempted from income for tax purposes by 26 U.S.C. § 108(a)(1)(A) if the debt is discharged in bankruptcy. If the debt is discharged in bankruptcy, it is NOT income and there is no tax liability.
One must take careful stock of pending short sales, foreclosures and the tendering of deeds in lieu of foreclosure to avoid the possibility of a nondischargeable tax liability being created before the debt is discharged in bankruptcy. In short, the debt must be subject to a discharge in bankruptcy before an event occurs outside of bankruptcy that would result in cancelled or forgiven debt.
For those homeowners who have refinanced their personal residence and used their home’s equity for something other than acquisition or a significant home improvement, bankruptcy clearly offers an avenue to avoiding a possible future tax liability. The same is true in the case of a property owner who is threatened with the foreclosure of a piece of property that is not his/her personal residence. Rental properties, unimproved real estate and vacation homes not having equity, all subject the owner to possible tax consequences in the event of a short sale or foreclosure. Obtaining a bankruptcy discharge before the cancellation of a debt can eliminate a possible tax consequence as discharged debt, unlike cancelled or forgiven debt, creates no tax liability.
If there is no bankruptcy discharge exclusion, the exclusion for cancelled debt under the Mortgage Forgiveness Debt Relief Act of 2007 may be used when a qualifying personal residence is involved.
A homeowner who is insolvent and wishes to use the insolvency exclusion when a qualifying personal residence is involved must elect to use the insolvency exclusion or the Mortgage Forgiveness Act will be applied by default. Electing to use the insolvency exclusion is important if there is non-qualifying debt on the personal residence that may subject the home owner to tax exposure if a foreclosure occurs and he/she is relying on the Mortgage Forgiveness Act. Avoidance of tax liability may be accomplished in this case by using the insolvency exclusion or the bankruptcy exclusion if the bankruptcy is filed before the debt cancelling event occurs. When using the insolvency exclusion, a balance sheet will have to be complied to document the insolvency.
After the taxpayer uses one of the exclusions to exclude forgiven debt from being counted as income for tax purposes, 26 U.S.C. § 108(b) requires a similar reduction in tax attributes. Most of them will not affect the average tax payer having little business or investment income, but may impact tax payers who use the alternative minimum tax. The scheme for applying reductions to tax attributes is set out in the statute. A tax professional should be consulted prior to filing the affected tax return[s] and form 982.
If Form 982, Reduction in Tax Attributes Due to Discharge of Indebtedness, is not filed with the tax return after a debt is forgiven, the IRS will send a notice of proposed tax increase. The notice will carry designation CP-2000. Expect the notice approximately 4 to 6 months after the tax return was filed. If you receive a CP-2000 notice of proposed tax increase, contact a tax professional immediately to assist you in a proper response.
I would suggest that an experienced bankruptcy attorney be consulted prior to allowing a foreclosure or short sale to be completed or before the settlement of any significant debt. Timing is crucial in seeking to ensure that any of the foregoing occurrences will not result in the creation of a tax obligation.