subject: Short Sales, Foreclosures And Loan Modifications Can Be A "tax Trap" For Homeowners And Investors [print this page] The downturn in the economy has led to a massive increase in the number of short sales, foreclosures and loan modifications being done for homeowners and investors. When lenders agree to reduce the amount of a mortgage or home equity loan in order to facilitate the sale of a property, agree to reduce the amount of a loan or accept less than the amount owed to them in a foreclosure sale, a taxable event has occurred for the owner of the property. The amount of the reduction of the loan or payment shortfall is considered to be a cancelled debt.
Generally speaking, the lender that agrees to a cancellation of debt will send the property owner a 1099-C for the amount of the loan principal reduction or shortfall. The property owner must report this income on their individual or business tax returns.
An Example
Patrick purchased a rental property in Connecticut in 2003 for $250,000 and got 100% mortgage financing on the property. Recently, he has been unable to rent it out for enough to cover the mortgage payments and is now a month behind on his mortgage. His still owes $235,000 on the mortgage but the property is now only worth $175,000. A buyer has offered to purchase the property from him and his bank has agreed to do a short sale on the property to avoid a foreclosure.
In this situation, Patrick will have cancellation of debt income amounting to $60,000 ($235,000 principal balance remaining on the mortgage less $175,000 purchase price). Patrick's lender will send him a 1099-C for $60,000 which Patrick will have to report on his personal income tax return and may have to pay taxes on that amount unless he qualifies for one of several exclusions from taxation allowed by the IRS tax code.
The Exclusions
There are several exclusions that permit a property owner to not have to report the cancellation of debt income or pay the income taxes due on cancellation of debt income. They are:
1. Bankruptcy Exemption - debt was cancelled in a Title 11 bankruptcy case if the cancellation of debt is approved by the court or occurs as a result of a plan approved by the court.
2. Insolvency Exemption - Taxpayer may exclude reporting of income if they were insolvent immediately before the cancellation of debt. This means the fair market value of all of the taxpayer's liabilities exceeded the fair market value of all of the taxpayer's assets immediately prior to the cancellation of debt.
3. Qualified Principal Residence Indebtedness - Taxpayer may exclude reporting of income if the property was their personal residence and all debt being cancelled related to the acquisition, construction, or improvement of the property. In this scenario, home equity loans or refinancing taken against the value of the property used to pay off credit cards or buy stuff not related to the home would not qualify for this exemption and would be taxable to the property owner.
The rules for reporting cancellation of debt income are complicated and require an experienced tax professional who is familiar with the tax laws and the exclusions available in the IRS tax code for avoiding tax on this income.
