Many real estate investors have serious financial problems due to declining real estate values and credit problems. During the past few months a large portion of my banrkuptcy and asset protection inquiries are from people who find themselves unable to pay mortgages they used to buy investment real estate near the end of the housing bubble. Several of my callers, and people who have become clients, have asked me about the consequences of giving a bank a deed in lieu of foreclosure or selling the property for less than full mortgage balance as part of an agreed “short sale.” (A “short sale” is where the bank agrees to accept less than the mortgage balance to release the mortgage in order to facilitate a sale and partial recovery of the loan).
One issue that frequently is discussed is the income tax consequences for the borrower from a short sale of deed in lieu as opposed to letting the bank foreclose. Income tax may be imposed for a cancellation of a debt. (“COD”) I am not an income tax professional. Recently, I posed the question to my personal CPA, Mr. Lonnie Young of Lake Mary, Florida, and asked him to explain the income tax consequences of giving property back to a mortgage lender.
Mr. Young responded that the borrower does not recognize income tax for COD from a foreclosure, but there is addtional income tax liability from either a short sale or a deed in lieu of foreclosure which results in COD. He reaffirmed my understanding that there is never COD income tax liability for people who file bankruptcy or are otherwise insolvent. He sent me a passage from one of his CPA tax books pertaining to the issue, which information I am quoting below for everyone’s benefit.
Why is it that I may have both gain (or loss) and COD income upon foreclosure of my house?
In many home foreclosures, the mortgage debt is recourse and the fair market value (FMV) of the house is less than the unpaid face amount of the debt. Often in this situation the borrower/debtor transfers the house to the lender (or to a third party), either through a deed in lieu of foreclosure or as a result of a foreclosure proceeding. This transfer is treated as a sale or other disposition of the property and results in the borrower/transferor realizing gain or loss. At the time of the transfer, the lender often cancels the remaining mortgage debt, leading to COD income.
Different rules may apply if the mortgage debt is nonrecourse.
What is COD income, and how is it calculated?
Loan proceeds are not included in income when received because there is an offsetting obligation to repay. However, if the debt is cancelled in part or full in a foreclosure proceeding, you will have COD income equaling the difference between the unpaid amount of the debt and the FMV of the property you transfer to the lender or a third party to discharge that debt. For example, if your debt prior to foreclosure was $200,000 and the FMV of the property was $170,000, you would have $30,000 of COD income.
Note: If you borrow money from a friend or relative and he or she cancels all or part of the debt, the cancellation often is treated as a gift from the lender to you. Gifts, including gifts of cancelled debts, are excludible from income. However, the cancellation of debt by a commercial lender is not a gift.
Can the amount of COD income be affected by other liabilities relating to the property?
The existence of other liabilities, such as property taxes, can either increase or reduce the amount of your COD income. For example, there may be unpaid property taxes that are treated as imposed on you for federal tax purposes. If you have not provided funds to pay the property taxes, the taxes generally either remain as unpaid charges against the property after foreclosure or must be satisfied from the sales proceeds from the foreclosed property prior to any application of such proceeds to satisfaction of the debt. The unpaid liabilities reduce the amount of the FMV of the property that is available for satisfaction of the debt and must be taken into account in computing the amount of COD income.
For example, suppose your debt prior to foreclosure was $200,000 and the FMV of the property was $170,000, but you had $10,000 of unpaid property taxes. In this situation, because the FMV of the property available to satisfy the debt would be only $160,000 ($170,000 FMV less $10,000 unpaid taxes), the COD income would be $40,000 ($200,000 debt less $160,000 FMV).
On the other hand, if you pay property taxes that for federal income tax purposes are treated as imposed on the owner of the property, this may reduce the amount of your cancelled debt income. Thus, if you paid $10,000 of property taxes that for federal income tax purposes are imposed on the owner of the property after the foreclosure, your FMV would be $180,000 ($170,000 plus $10,000) and your COD income would be $20,000 ($200,000 debt less $180,000 FMV).
How do I compute gain or loss on a disposition by foreclosure?
Gain or loss is the difference between your amount realized and your adjusted basis in the property. In general, an amount realized by the transferor on a foreclosure or other transfer of property is the sum of:(1) the amount of money received; (2) the FMV of any other property received; and (3) the amount of any other liabilities that the transferee (the person acquiring the property) either assumes or takes the property subject to.
Give an example involving recourse debt in which both gain and COD income results on the foreclosure.
If the face amount of the recourse debt is $200,000, the FMV of the property is $170,000, and the adjusted basis is $120,000, you have $30,000 of COD income ($200,000 debt less $170,000 FMV) and $50,000 of gain ($170,000 FMV (amount realized) less $120,000 adjusted basis).
If the mortgage debt is nonrecourse, is there COD income on the foreclosure?
If your mortgage debt is nonrecourse, the debt is greater than the FMV of the house, and the house is foreclosed upon, your amount realized will be the face amount of the unpaid mortgage debt. Thus, if the amount of the nonrecourse debt is $200,000, the FMV of the property is $170,000, and the adjusted basis of the property is $120,000, your gain on foreclosure is $80,000 ($200,000 amount realized less $120,000 adjusted basis). No portion of the gain on property subject only to nonrecourse debt is COD income.
If your house is foreclosed upon and your mortgage debt is recourse, are there circumstances in which you may have gain or loss but not COD income?
There are at least two situations involving recourse debt in which foreclosure results in gain or loss, but not in COD income.
First, sometimes when a house is transferred to the lender by foreclosure the lender does not cancel the remaining unpaid portion of the debt. This could happen if the lender believes it can still collect the balance of the debt. In that circumstance, you would not have COD income until the lender discharged the debt or the statute of limitations on collection of the debt expired. The gain or loss on the foreclosure is the difference between the FMV of the property and its adjusted basis.
Second, sometimes the FMV of a house that is foreclosed upon is greater than the amount of the debt. If the FMV is sufficient to pay the debt in full, the debt is satisfied and there is no COD income because no part of the debt was discharged or cancelled. For example, if the FMV of the house was $200,000, the amount of the debt was $140,000, and the adjusted basis of the house was $110,000, the gain on the sale of the house is $90,000 ($200,000 FMV (amount realized) less $110,000 adjusted basis), but there is no COD income because the FMV of the house is $60,000 ($200,000 FMV less $140,000 debt), which is more than enough to satisfy the debt in full.
Can COD income ever be excluded from my gross income?
You may be able to exclude all or part of the cancelled debt income if all or part of the debt was discharged in bankruptcy, if you were insolvent immediately before the transfer, or if the debt is a qualified farm debt or qualified real property indebtedness. Refer to Publication 908 (PDF),Bankruptcy Tax Guide.
How do I report COD income on my return?
COD income is ordinary income and is reported on Line 21 of your return.
Can gain on the foreclosure of my house be excluded from my gross income?
If the house is your principal residence, you may be able to exclude part of all of the gain under I.R.C. 121. See Publication 523, Selling Your Home.
How do I report a foreclosure gain or loss on my return?
Gain or loss on the foreclosure of your house usually is capital gain or loss. However, a loss on the foreclosure of your residence is not deductible. Capital gains are reported on Form 1040, Schedule D (PDF). If, however, the gain on the foreclosure of your residence is excluded under I.R.C. 121, you are not required to report the gain on your return.
posted by Jonathan Alper, asset protection and bankruptcy attorney, Orlando, Florida