TAX CONSEQUENCES OF CANCELLATION OF DEBT THROUGH A FORECLOSURE, "DEED IN LIEU," A SHORT SALE OR THROUGH FORGIVENESS OF CONSUMER DEBT (CREDIT CARDS, ETC.)

The information in this article applies to both federal and California Tax Law. Be cautious however, because the amount of maximum relief from cancellation of debt, and the amount of debt to which the relief may be applied, varies between federal and California law.

NOTE: The terms loans, mortgages and deeds of trust are used interchangeably in this article as relating to indebtedness secured by real property.

As of this writing, in May of 2010, we are still receiving several calls a week regarding this issue. Clients have found themselves suddenly "upside down" in their real property, due either to a high consumer debt load or a mortgage payment which has adjusted upward dramatically. While we are not  consumer debt or bankruptcy attorneys, we can discuss some of the tax consequences which might result from allowing property to go into foreclosure, or by arranging for a "short sale" with the lender. There are several important tax aspects, some of which require immediate planning to avoid later adverse tax consequences.

What kind of debt is it?

The two kinds of indebtedness for tax purposes are recourse and non-recourse. we are going to over-simplify this distinction for now by describing a purchase money mortgage (one used to buy your home) as non-recourse and a refinance as recourse. Non-recourse debt means the creditor cannot come after your other assets. The only remedy available is for the lender to take the security (the property). So if you walk away from your house with non-recourse debt, the lender cannot seek what is called a "deficiency judgment" against you putting you on the hook for any money lost by personally suing you after the property is sold.

Recourse debt is where the lender does have the ability to come after you for the difference in value between what they can sell the home for and what you owed.

That said, the chances of actually seeing a deficiency judgment from a first trust deed are not good. This is because there are actually two forms of foreclosure. The first type is a judicial foreclosure, where the creditor actually obtains a judgment as the result of a lawsuit. The defaulting homeowner then has a limited right of redemption. In addition, California has what is termed the "one action rule," which essentially means the creditor is required to go after the collateral first. This prevents the creditor from simply obtaining a money judgment for the total amount of the debt.  In this type of action, the creditor may obtain a deficiency judgment unless the provisions of California's anti-deficiency laws apply. This is generally applicable to debt secured by the property and used to purchase it (discussed above). Refinancing a loan removes this protection and subjects the borrowers to personal liability. In addition, if a junior lienholder is wiped out because there is insufficient security to move against, the junior lienholder of a recourse loan may seek a judgment.

The second type of foreclosure, like most all foreclosures in California is executed through the "power of sale" found in the standard Deed of Trust associated with the loan. The exercise of the power of sale is not considered a legal action, and therefore no deficiency judgment may result. Lenders invariably use this method because it is much easier and quicker, and does not have any allowance for a later redemption of the property by the debtor. Unless the loan was used to purchase the property and was secured by that property, it will probably be recourse debt.  This is because, even though the use of the power of sale will not permit a deficiency judgment personally against the debtor, the option is still open to the lender initially because the anti-deficiency restrictions do not apply. Once the lender has elected to exercise the power of sale, however, they are precluded from attempting to obtain a judicial judgment.

So, to summarize - the loans used to buy the property as a residence with 1-4 units are non-recourse. Refinanced loans, or those used to purchase non-residential property, or residential property with more than four units are almost always recourse loans.

 Tax Consequences

Cancellation of Indebtedness

Many people are surprised there are tax consequences to a foreclosure or short sale, especially the fact that potential income is created. How, they ask, can there be income at the very time when we are desperately in debt? The source of the "income" stems from basic tax law, where income is defined as an "accession to wealth." Again, hearing about acceding to wealth when you are losing your home seems ridiculous, but it is because of the tax treatment of loans.

When you take out ten thousand dollars from your line of credit to remodel the kitchen, it is not income. Why? Because there is an offsetting balance. You may be ten thousand dollars richer in your checking account, but you now owe ten thousand dollars to someone else. The two transactions cancel each other out. You have therefore not "acceded to wealth." You have no "income" for purposes of the Internal Revenue Code.   But what happens when one side of the equation is disturbed. Say your lender had a contest with the prize being a forgiveness of your ten thousand dollar line of credit balance, and you win. Now you have the ten thousand dollars but no corresponding debt owed. You have acceded to wealth because that ten thousand dollars is now "free and clear." You have cancellation of indebtedness income, and the lender will be required to report this as income to the IRS on a Form 1099-C.

Bringing these principles into the arena of real estate ownership, when you walk away from a property, or arrange a short sale, some of the debt which offset your initial loan is no longer there. The tax law considers you to have been "enriched" by the amount of debt you no longer have to pay back. This is where the potential for income is created in a foreclosure or short sale scenario. But the tax treatment of recourse versus non-recourse debt is very different.

The first step - determine your basis

Before it is possible to calculate the capital gains portion of any real estate tax liability, the adjusted basis of the property must be calculated. For a personal residence this is straightforward. It is the purchase price plus the value of improvements. For an income property it will be the purchase price plus the value of improvements and minus any depreciation allowed or allowable. If your residence was converted to a rental then the depreciation would be that allowed or allowable while the property was actively held out for rent. To the basis of either personal or rental properties you are allowed to add the value of "substantial improvements." These improvements, however, must be well documented, as the IRS will require proof if this ever becomes an issue.

Non-Recourse loans

This is a relatively simple situation, rarely holding adverse tax consequences. Upon the foreclosure or short sale of the property, where the loans are those used to acquire, build or substantially improve the property, the property is taxed as if it were sold for the total outstanding amount of the loan (or sales price, if higher).  Then, normal capital gains consequences flow from this price. If this is a personal residence, and the owners have met the requirements of Internal Revenue Code section 121 (for most taxpayers this requires they lived in and owned the home for two years) then the normal $250,000 ($500,000 filing joint) exclusion will apply and no tax will be owed. Again, if the loan from which the forgiveness will come is the original loan used to construct, substantially improve or acquire a personal dwelling, this law will apply. A refinance will almost always result in the loss of this statutory protection.

Recourse loans

In the case of recourse debt, there are actually two components. First is capital gain and the second is cancellation of indebtedness (COD) income.

Short sales and foreclosures are taxed identically. Here are how the two components are calculated. The only advantage is that a foreclosure usually results in the issuance of a form 1099-A. This tends to show the 'full credit bid" of the first lender at the trustee sale and thus rarely shows any cancellation of debt. A short sale, on the other hand, usually results in the issuance of a Form 1099-C, which does generate the potential for cancellation of debt income. Creditors, however, are under no obligation whatsoever to bid the "full credit" price, and if they choose to bid lower there will be cancelled debt involved. Also remember,  a advantageous "full credit" Form 1099-A issued by the first lender will not prevent the issuance of a Form 1099-C by any second or third lenders.

Capital gain is the fair market value (FMV) of the property minus the adjusted basis.  As with the non-recourse debt, the homeowner's provisions of section 121 are available to offset this gain. So if the home was purchased for $100,000 and $20,000 of improvements were added, the adjusted basis would be $120,000. A sale for $200,000 would result in capital gain of $80,000.

Cancellation of indebtedness income is calculated by taking the amount of the debt forgiven and subtracting the fair market value. So in our previous example, if the owners had refinanced and had debt totaling $250,000, their COD income would be $50,000 (total debt of $250,000 minus the FMV of $200,000).

In total, the taxpayers would have $80,000 of capital gain and $50,000 of COD income.

THE MORTGAGE DEBT FORGIVENESS ACT OF 2007

In December, 2007 the president signed a bill grant mortgage relief to many taxpayers who otherwise would have incurred substantial taxes because if cancellation f indebtedness income realized from foreclosures, short sales and "deed in lieu" dispositions of their primary residence. The new federal law allows these taxpayers to exclude cancellation of indebtedness income on acquisition debt up to 2 million dollars.

So obviously the first question is, "What is acquisition debt." The answer will not be pleasant to many. Acquisition debt is indebtedness taken on to acquire, construct or substantially improve one' primary residence. Unfortunately, it will not include refinanced money which went to pay off credit cards, buy boats or fund vacations. To the extent your refinance went for these purposes, you are going to have taxable income, unless you fall into the insolvency category as discussed below, or you went into, and were successfully discharged from bankruptcy. Fortunately for many of our clients, the extra money taken out went right back into the house. This is acquisition debt, and will be covered by the new law.

Exceptions to the inclusion of COD into gross income

Here is where advance planning may be quite useful. If you do not qualify for relief from cancellation of indebtedness income under the new law described above, the Internal Revenue Code provides a couple of situations where a taxpayer does not have to include COD income in gross income. The most common two situations are first, bankruptcy, and second, insolvency.

COD income need not be included in gross income if the debt has been discharged by the Bankruptcy Court in an action under Title 11 of the US Code. That's all there is to that.

COD income need not be included in gross income to the extent the taxpayer is insolvent just before the cancellation of the debt. Insolvency is determined by subtracting liabilities from assets. If, for example, at the time a $50,000 debt is cancelled, you have only $20,000 in assets, you will not have to pay any income tax on the amount equal to the difference, $30,000. For many of you who are not only "upside down" on your homes, but have a great deal of consumer debt, your liabilities may be so much greater than your assets that you will owe no tax at all.

That may be good news until we provide you with more information, however. Even though you have no access to the money, all the dollars in your retirement accounts will count as assets. This includes government retirement plans such as PERS or a 1937 Act county retirement account, 403(b), 457 (deferred Compensation), IRA's and 401(k) accounts. The cash surrender value of life insurance is also included.

Nonetheless, if faced with a massive tax bill at the very time you are least equipped to deal with it, an aggressive review of your assets and liabilities should be done. Here is what we recommend.

Assemble evidence of all assets and liabilities. This means statements current as of the time you will likely have COD income as discussed above. The IRS might not challenge you for a year or two, and trying to assemble this information will be very difficult. The IRS will not just accept a balance sheet. They will want proof you are insolvent and to what extent. Statements of accounts, both positive and negative, from around the time of the COD income will prepare you for this challenge. Do a balance sheet with these documents and you will have an idea where you stand. Once you have this information you may discuss specifics of your situation with either Kevin or we as tax season approaches. But it is critical to assemble this information at the time it is actually relevant. If you try to use this exception but do not have these documents ready, you cannot win.

Beware the "transfer" scam

If you see a pitch from a company who says they will get you out from under cancellation of indebtedness income beware. For a fee, these companies will claim you need only transfer the deed to them and thus they will assume the resulting tax liability. This simply isn't true. The transfer of title to such a company will only be considered a transfer to an agent and not a bona fide sale. The potential COD income will still accrue to the original owner, no matter what you are told to the contrary.

Loan Modification

A major exception to the protections afforded by the non-recourse nature of California "purchase money mortgages" is where, in a loan modification, a portion of the loan principal is reduced and the security (the house) is not given up in a short sale, foreclosure or other final disposition.  Be careful you are aware of the tax consequences in this situation as they are different than in most non-recourse debt situations.

Consumer Debt

 Almost without exception, consumer debt from personal loans, auto loans, credit cards and revolving credit accounts is recourse debt. So when this type of debt is forgiven through some type of worked out arrangement, income from cancellation of debt will result and a Form 1099-C will be issued. There are only two ways to exclude type of debt, and those are the bankruptcy and the insolvency exceptions.

Debt Forgiveness for Tax is not the Same as Debt Forgiveness Altogether

Just because a lender sends you an IRS Form which states a given debt has been "forgiven," don't actually rely on this as evidence the debt has been forgiven. Why? Because there is simply no relationship between the issuance of an IRS Form and the existence of creditors rights under state law. Sure, in a lawsuit against you to recover your money, you can pull out the IRS form in your defense, but it really means nothing. It does not meet the legal requirements for a release from a financial obligation in California, for example.

If you want to protect yourself from a lawsuit anytime in the four years a lender has from a contract breach to sue you, consult an attorney who practices in California civil law, because the tax advice you receive, while it may be completely relevant to taxation, will be useless in the face of a state law action by a creditor.