Beware The Taxes That Follow Foreclosure

Who cares about stopping the foreclosure, it’s stopping the tax that results from foreclosure.

It’s a brand new perspective for me as I counsel families with homes at risk of foreclosure.  Given mortgage debt that exceeds today’s value of the property, a foreclosure will result in a 1099 for the difference between the loan balance and the current market value of the property, as selected by the creditor.  Absent one of the statutory safe harbors, that dollar amount is includible in taxable income.  Ouch!

Bankruptcy is one of those safe harbors.

Internal Revenue Code Section 108 provides that income from cancellation of debt is not includible in gross income if the discharge of the debt occurred in a case under Title 11.  That’s been an advantage of bankruptcy over debt settlement that’s been part of our arsenal for a while.  But with falling home values, I’m now seeing bankruptcies that are necessary only because of the otherwise horrific tax cost of foreclosure .

Insolvency is also a defense to inclusion of the income, but it’s insolvency under the IRS rules that includes the value of exempt property and retirement savings.  I’ve seen recently several clients with multiple properties and an opinion from their tax guy that they needn’t worry, they’re insolvent.  Yeah, maybe today, before the first foreclosure.  Will it be the same when the last property is foreclosed?

Of course, the tax law has lots of wrinkles in application.  There is no risk of COD income if there is no personal liability on the discharged debt.  What about short sales?  Loan modifications?

My friend Bill Purdy,  mortgage lending  lawyer and tax professor, is going to answer all my questions at his presentation Debt & Tax Collide on April 9th in San Jose.  I’ll report back on what I learn about the inner workings of cancellation of debt income.  If you’re in Northern California, join us.  If not, watch for release of the program on “tape”.

Image courtesy of River Beach

Related Posts Plugin for WordPress, Blogger...
  • Seth R.

    My understanding was that “short sales” or “deeds in lieu of foreclosure” that resulted in a large amount of debt being written off were taxable events. But I heard somewhere that Congress put a moratorium on that – making it temporarily non-taxable. Is this true?

    • Anonymous

      I hope to know after next Saturday’s training. The whole issue makes my
      head hurt, but I don’t suppose that’s a defense to malpractice.

    • Cathy

      Now I think I know: the moratorium on inclusion in taxable income for cancellation of debt applies (through 2012) to principal residences where the loan generating the forgiveness is purchase money, or a refinance of a purchase money loan where no cash was acquired and used for anything other than improvements to the home.

      State law may not mirror the fed treatment.