Tax Consequences of Foreclosure, Short Sale and Deed in Lieu of Foreclosure
Tax Consequences of Foreclosure, Short Sale and Deed in Lieu of Foreclosure
Christopher M. Riser
A distressed real property owner facing the prospect of a foreclosure, short sale or deed in lieu of foreclosure may be surprised to discover that these events can lead to income taxation of capital gain or cancellation of indebtedness ("COD") income. For purposes of this article, I'll use the term "distressed property disposition" to refer to a foreclosure, short sale or deed in lieu of foreclosure.
The tax results of a distressed property disposition depend on whether the loan is a "recourse" loan or a "non-recourse" loan. If a lender's sole option for recovering on the loan is to take back the property, it is a non-recourse loan. The non-recourse aspect of a loan may be spelled out in the loan documents, or it may be a matter of state law, as it often is in the case of purchase-money loans and seller-financed loans for owner-occupied residential property. If the lender can pursue the borrower personally for any shortfall, it is a recourse loan. In situations where there is a shortfall on a recourse loan, the lender is supposed to send the IRS and the borrower a form 1099-C reporting the borrower’s COD income.
Non-Recourse Loan Tax Consequences
In the case of a distressed property disposition with a non-recourse loan, the disposition is taxed as if it were sold for the greater of the outstanding debt or the sales price. The nature of the gain and the deductibility of any loss depend on the holding period and the nature of the property as with any other disposition. The following examples are simplified. Adjusted tax basis for calculating gains and losses can be affected by more than just purchase price and depreciation; and the deemed sales price in a disposition by a deed in lieu of foreclosure includes past due interest, but may be offset by a deduction for that interest.
Example #1: Ann owes $500,000 on her personal residence she bought for $700,000, which now has a market value of $400,000. Ann is taxed on a distressed disposition of the property as if she sold the property for $500,000, and she has a personal loss of $200,000, which is not deductible.
Example #2: Bill owes $1,000,000 on his personal residence he bought for $950,000, which now has a market value of $1,050,000. Bill is taxed on a distressed disposition of the property as if he sold the property for $1,050,000, and he has a gain of $50,000, which may be excludible from income if Bill meets the 2-year ownership and residency test of IRC Sec. 121.
Example #3: Carla owes $1,000,000 on a commercial property she bought for $1,100,000, which is now worth $800,000. She has taken $200,000 in depreciation deductions. Carla is taxed on a distressed disposition of the property as if she sold the property for $1,000,000. Carla is taxed as if she had sold the property for $1,000,000, and she has taxable depreciation recapture of $100,000.
Recourse Loan Tax Consequences
For a loan to be treated as a recourse loan, the lender must have the ability to pursue the borrower personally under the terms of the loan document and under state law. Generally, that means that if the property brings the lender less than the outstanding loan amount, the lender must obtain a "deficiency judgment." As a practical matter, in many states, this often does not happen, because it involves more legal work and usually does not pay off for lenders. However, don't be surprised to see junk debt collectors getting into this market, in which case, we may see more deficiency judgments than in the past.
In the case of a distressed disposition of property subject to a recourse loan, in addition to the potential income and gain resulting from the sale for value, there also may be COD income if the debt exceeds the value of the property. COD income is taxed at ordinary income rates.
Example #4: Don owes $500,000 on his personal residence he bought for $700,000, which now has a market value of $400,000. He lives in a state where lenders can pursue deficiency judgments against residential borrowers. Don is taxed on a distressed disposition of the property as if he sold the property for $500,000, and he has a loss of $200,000, which is not deductible. He also has COD income of $100,000.
Example #5: Ethel owes $900,000, on a recourse basis, on a luxury condo investment property she bought for $1,000,000, which now has a market value of $600,000. She has taken $100,000 in depreciation deductions. Ethel is taxed on a distressed disposition of the property as if she sold the property for $900,000. She has COD income of $300,000, and a long-term capital loss of $300,000.
Example #6: Frank owes $2,000,000, on a recourse basis, on a commercial property he bought for $500,000, which now has a market value of $1,500,000. He has taken $200,000 in depreciation deductions. Frank is taxed on a distressed disposition of the property as if he sold the property for $2,000,000. He has COD income of $500,000, depreciation recapture of $200,000, and a long-term capital gain of $1,000,000.
Exceptions to Taxability of COD Income
COD income is not taxable if the debt is discharged as part of a bankruptcy proceeding. In addition, some or all of the COD income may not taxable if you are insolvent at the time the debt is cancelled. For example, if you owns assets with a fair market value of $2,000,000 and has liabilities of $2,250,000, only $250,000 (the amount by which he is insolvent) can be excluded if the liabilities are discharged. Determining insolvency for these purposes can be complex, and the assistance of a tax professional likely will be required to make this determination. However, the excluded COD income will reduce other tax attributes such as basis, current and carryover losses, etc. So, COD income could still give rise to additional tax, even if it is excluded from current income.
There are also exceptions for COD income arising from the cancellation of qualified farm indebtedness and qualified business indebtedness. However, qualified business indebtedness likely will not include loans for commercial or residential rental property.
Example #7: Gina owes $3,000,000, on a recourse basis, on a commercial property she bought for $1,000,000, which now has a market value of $2,500,000. She has taken $300,000 in depreciation deductions. She is taxed on a distressed disposition of the property as if she sold the property for $3,000,000. She has COD income of $500,000. However, after the discharge of the debt, she is solvent only by $200,000., so $300,000 of the $500,000 COD income is not taxable, and instead will reduce other tax attributes, such as her $100,000 ordinary loss carryover from last year. So, she has taxable COD income of $200,000, depreciation recapture of $300,000, her ordinary loss carryover is reduced by $100,000 to zero, and her basis in the property is reduced by $200,000, so that she has a long-term capital gain of $1,700,000.
Mortgage Forgiveness Debt Relief Act of 2007
Finally, in late 2007, Congress provided some relief from taxation of COD income in the case of "Qualified Principal Residence Indebtedness." QPRI is a loan secured by the principal residence used to acquire, construct or substantially improve the residence. For refinances, this amount is capped at $2,000,000 ($1,000,000 for a married person filing a separate return).
Under the Mortgage Forgiveness Debt Relief Act of 2007, IRC Sec. 108(a)(1)(E) was added and provides that for the period January 1, 2007 through December 31, 2009, COD income from QPRI is not taxed. However, it's not a complete freebie. As with the insolvency exception, any reduction of indebtedness under the QPRI exception will reduce the basis in the property. So, this could still give rise to capital gain.
Example #8: Harry and Helga owe $2,000,000 on their personal residence, which they bought several years ago for $1,000,000, and which is now worth $1,500,000. They live in a state where lenders can pursue deficiency judgments against residential borrowers. They are taxed on a distressed disposition of the property in 2008 as if they sold the property for $2,000,000. They have $500,000 of COD income, but it is not taxable. However, their basis is reduced by $500,000, so they have a capital gain of $1,000,000, of which $500,000 is excludable under IRC Sec. 121 as gain on the sale of a principal residence. So, they will be taxed on $500,000 of capital gain.
Christopher M. Riser
A distressed real property owner facing the prospect of a foreclosure, short sale or deed in lieu of foreclosure may be surprised to discover that these events can lead to income taxation of capital gain or cancellation of indebtedness ("COD") income. For purposes of this article, I'll use the term "distressed property disposition" to refer to a foreclosure, short sale or deed in lieu of foreclosure.
The tax results of a distressed property disposition depend on whether the loan is a "recourse" loan or a "non-recourse" loan. If a lender's sole option for recovering on the loan is to take back the property, it is a non-recourse loan. The non-recourse aspect of a loan may be spelled out in the loan documents, or it may be a matter of state law, as it often is in the case of purchase-money loans and seller-financed loans for owner-occupied residential property. If the lender can pursue the borrower personally for any shortfall, it is a recourse loan. In situations where there is a shortfall on a recourse loan, the lender is supposed to send the IRS and the borrower a form 1099-C reporting the borrower’s COD income.
Non-Recourse Loan Tax Consequences
In the case of a distressed property disposition with a non-recourse loan, the disposition is taxed as if it were sold for the greater of the outstanding debt or the sales price. The nature of the gain and the deductibility of any loss depend on the holding period and the nature of the property as with any other disposition. The following examples are simplified. Adjusted tax basis for calculating gains and losses can be affected by more than just purchase price and depreciation; and the deemed sales price in a disposition by a deed in lieu of foreclosure includes past due interest, but may be offset by a deduction for that interest.
Example #1: Ann owes $500,000 on her personal residence she bought for $700,000, which now has a market value of $400,000. Ann is taxed on a distressed disposition of the property as if she sold the property for $500,000, and she has a personal loss of $200,000, which is not deductible.
Example #2: Bill owes $1,000,000 on his personal residence he bought for $950,000, which now has a market value of $1,050,000. Bill is taxed on a distressed disposition of the property as if he sold the property for $1,050,000, and he has a gain of $50,000, which may be excludible from income if Bill meets the 2-year ownership and residency test of IRC Sec. 121.
Example #3: Carla owes $1,000,000 on a commercial property she bought for $1,100,000, which is now worth $800,000. She has taken $200,000 in depreciation deductions. Carla is taxed on a distressed disposition of the property as if she sold the property for $1,000,000. Carla is taxed as if she had sold the property for $1,000,000, and she has taxable depreciation recapture of $100,000.
Recourse Loan Tax Consequences
For a loan to be treated as a recourse loan, the lender must have the ability to pursue the borrower personally under the terms of the loan document and under state law. Generally, that means that if the property brings the lender less than the outstanding loan amount, the lender must obtain a "deficiency judgment." As a practical matter, in many states, this often does not happen, because it involves more legal work and usually does not pay off for lenders. However, don't be surprised to see junk debt collectors getting into this market, in which case, we may see more deficiency judgments than in the past.
In the case of a distressed disposition of property subject to a recourse loan, in addition to the potential income and gain resulting from the sale for value, there also may be COD income if the debt exceeds the value of the property. COD income is taxed at ordinary income rates.
Example #4: Don owes $500,000 on his personal residence he bought for $700,000, which now has a market value of $400,000. He lives in a state where lenders can pursue deficiency judgments against residential borrowers. Don is taxed on a distressed disposition of the property as if he sold the property for $500,000, and he has a loss of $200,000, which is not deductible. He also has COD income of $100,000.
Example #5: Ethel owes $900,000, on a recourse basis, on a luxury condo investment property she bought for $1,000,000, which now has a market value of $600,000. She has taken $100,000 in depreciation deductions. Ethel is taxed on a distressed disposition of the property as if she sold the property for $900,000. She has COD income of $300,000, and a long-term capital loss of $300,000.
Example #6: Frank owes $2,000,000, on a recourse basis, on a commercial property he bought for $500,000, which now has a market value of $1,500,000. He has taken $200,000 in depreciation deductions. Frank is taxed on a distressed disposition of the property as if he sold the property for $2,000,000. He has COD income of $500,000, depreciation recapture of $200,000, and a long-term capital gain of $1,000,000.
Exceptions to Taxability of COD Income
COD income is not taxable if the debt is discharged as part of a bankruptcy proceeding. In addition, some or all of the COD income may not taxable if you are insolvent at the time the debt is cancelled. For example, if you owns assets with a fair market value of $2,000,000 and has liabilities of $2,250,000, only $250,000 (the amount by which he is insolvent) can be excluded if the liabilities are discharged. Determining insolvency for these purposes can be complex, and the assistance of a tax professional likely will be required to make this determination. However, the excluded COD income will reduce other tax attributes such as basis, current and carryover losses, etc. So, COD income could still give rise to additional tax, even if it is excluded from current income.
There are also exceptions for COD income arising from the cancellation of qualified farm indebtedness and qualified business indebtedness. However, qualified business indebtedness likely will not include loans for commercial or residential rental property.
Example #7: Gina owes $3,000,000, on a recourse basis, on a commercial property she bought for $1,000,000, which now has a market value of $2,500,000. She has taken $300,000 in depreciation deductions. She is taxed on a distressed disposition of the property as if she sold the property for $3,000,000. She has COD income of $500,000. However, after the discharge of the debt, she is solvent only by $200,000., so $300,000 of the $500,000 COD income is not taxable, and instead will reduce other tax attributes, such as her $100,000 ordinary loss carryover from last year. So, she has taxable COD income of $200,000, depreciation recapture of $300,000, her ordinary loss carryover is reduced by $100,000 to zero, and her basis in the property is reduced by $200,000, so that she has a long-term capital gain of $1,700,000.
Mortgage Forgiveness Debt Relief Act of 2007
Finally, in late 2007, Congress provided some relief from taxation of COD income in the case of "Qualified Principal Residence Indebtedness." QPRI is a loan secured by the principal residence used to acquire, construct or substantially improve the residence. For refinances, this amount is capped at $2,000,000 ($1,000,000 for a married person filing a separate return).
Under the Mortgage Forgiveness Debt Relief Act of 2007, IRC Sec. 108(a)(1)(E) was added and provides that for the period January 1, 2007 through December 31, 2009, COD income from QPRI is not taxed. However, it's not a complete freebie. As with the insolvency exception, any reduction of indebtedness under the QPRI exception will reduce the basis in the property. So, this could still give rise to capital gain.
Example #8: Harry and Helga owe $2,000,000 on their personal residence, which they bought several years ago for $1,000,000, and which is now worth $1,500,000. They live in a state where lenders can pursue deficiency judgments against residential borrowers. They are taxed on a distressed disposition of the property in 2008 as if they sold the property for $2,000,000. They have $500,000 of COD income, but it is not taxable. However, their basis is reduced by $500,000, so they have a capital gain of $1,000,000, of which $500,000 is excludable under IRC Sec. 121 as gain on the sale of a principal residence. So, they will be taxed on $500,000 of capital gain.
Labels: capital gain, cod, foreclosure, income tax
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