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Home Foreclosure and Debt Cancellation
The Mortgage Forgiveness Debt Relief Act of 2007 generally allows taxpayers to exclude income from the discharge of debt on their principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualify for this relief.
This provision applies to debt forgiven in calendar years 2007 through 2012. Up to $2 million of forgiven debt is eligible for this exclusion ($1 million if married filing separately). The exclusion doesn’t apply if the discharge is due to services performed for the lender or any other reason not directly related to a decline in the home’s value or the taxpayer’s financial condition.
The amount excluded reduces the taxpayer’s cost basis in the home. More details. Further information, including detailed examples, can also be found in Publication 4681, [see also a summary of this publication posted on this blog Canceled Debts, Foreclosures, Repossessions, and Abandonments ]
The questions and answers, below, are based on the law prior to the passage of the Mortgage Forgiveness Debt Relief Act of 2007.
1. What is Cancellation of Debt?
If you borrow money from a commercial lender and the lender later cancels or forgives the debt, you may have to include the cancelled amount in income for tax purposes, depending on the circumstances. When you borrowed the money you were not required to include the loan proceeds in income because you had an obligation to repay the lender. When that obligation is subsequently forgiven, the amount you received as loan proceeds is reportable as income because you no longer have an obligation to repay the lender. The lender is usually required to report the amount of the canceled debt to you and the IRS on a Form 1099-C, Cancellation of Debt.
Here’s a very simplified example. You borrow $10,000 and default on the loan after paying back $2,000. If the lender is unable to collect the remaining debt from you, there is a cancellation of debt of $8,000, which generally is taxable income to you.
2. Is Cancellation of Debt income always taxable?
Not always. There are some exceptions. The most common situations when cancellation of debt income is not taxable involve:
Bankruptcy: Debts discharged through bankruptcy are not considered taxable income.
Insolvency: If you are insolvent when the debt is cancelled, some or all of the cancelled debt may not be taxable to you.You are insolvent when your total debts are more than the fair market value of your total assets.Insolvency can be fairly complex to determine and the assistance of a tax professional is recommended if you believe you qualify for this exception.
Certain farm debts:If you incurred the debt directly in operation of a farm, more than half your income from the prior three years was from farming, and the loan was owed to a person or agency regularly engaged in lending, your cancelled debt is generally not considered taxable income.The rules applicable to farmers are complex and the assistance of a tax professional is recommended if you believe you qualify for this exception.
Non-recourse loans:A non-recourse loan is a loan for which the lender’s only remedy in case of default is to repossess the property being financed or used as collateral.That is, the lender cannot pursue you personally in case of default.Forgiveness of a non-recourse loan resulting from a foreclosure does not result in cancellation of debt income.However, it may result in other tax consequences, as discussed in Question 3 below.
3. I lost my home through foreclosure. Are there tax consequences?
There are two possible consequences you must consider:
Taxable cancellation of debt income.(Note: As stated above, cancellation of debt income is not taxable in the case of non-recourse loans.)
A reportable gain from the disposition of the home (because foreclosures are treated like sales for tax purposes).(Note: Often some or all of the gain from the sale of a personal residence qualifies for exclusion from income.)
Use the following steps to compute the income to be reported from a foreclosure:
Step 1 – Figuring Cancellation of Debt Income (Note: For non-recourse loans, skip this section. You have no income from cancellation of debt.)
1. Enter the total amount of the debt immediately prior to the foreclosure.___________2. Enter the fair market value of the property from Form 1099-C, box 7. ___________3. Subtract line 2 from line 1.If less than zero, enter zero.___________
The amount on line 3 will generally equal the amount shown in box 2 of Form 1099-C. This amount is taxable unless you meet one of the exceptions in question 2. Enter it on line 21, Other Income, of your Form 1040.
The amount on line 3 will generally equal the amount shown in box 2 of Form 1099-C. This amount is taxable unless you meet one of the exceptions in question 2. Enter it on line 21, Other Income, of your Form 1040.
Step 2 – Figuring Gain from Foreclosure4. Enter the fair market value of the property foreclosed.For non-recourse loans, enter the amount of the debt immediately prior to the foreclosure ________5. Enter your adjusted basis in the property.(Usually your purchase price plus the cost of any major improvements.) ____________6. Subtract line 5 from line 4. If less than zero, enter zero.
The amount on line 6 is your gain from the foreclosure of your home. If you have owned and used the home as your principal residence for periods totaling at least two years during the five year period ending on the date of the foreclosure, you may exclude up to $250,000 (up to $500,000 for married couples filing a joint return) from income. If you do not qualify for this exclusion, or your gain exceeds $250,000 ($500,000 for married couples filing a joint return), report the taxable amount on Schedule D, Capital Gains and Losses.
4. I lost money on the foreclosure of my home. Can I claim a loss on my tax return?
No. Losses from the sale or foreclosure of personal property are not deductible.
5. Can you provide examples?
A borrower bought a home in August 2005 and lived in it until it was taken through foreclosure in September 2007. The original purchase price was $170,000, the home is worth $200,000 at foreclosure, and the mortgage debt canceled at foreclosure is $220,000. At the time of the foreclosure, the borrower is insolvent, with liabilities (mortgage, credit cards, car loans and other debts) totaling $250,000 and assets totaling $230,000.
The borrower figures income from the foreclosure as follows:
Use the following steps to compute the income to be reported from a foreclosure:
Step 1 – Figuring Cancellation of Debt Income (Note: For non-recourse loans, skip this section. You have no income from cancellation of debt.)
1. Enter the total amount of the debt immediately prior to the foreclosure.___$220,000__2. Enter the fair market value of the property from Form 1099-C, box 7. ___$200,000__3. Subtract line 2 from line 1.If less than zero, enter zero.___$20,000__
The amount on line 3 will generally equal the amount shown in box 2 of Form 1099-C. This amount is taxable unless you meet one of the exceptions in question 2. Enter it on line 21, Other Income, of your Form 1040.
The amount on line 3 will generally equal the amount shown in box 2 of Form 1099-C. This amount is taxable unless you meet one of the exceptions in question 2. Enter it on line 21, Other Income, of your Form 1040.
Step 2 – Figuring Gain from Foreclosure
4. Enter the fair market value of the property foreclosed.For non-recourse loans, enter the amount of the debt immediately prior to the foreclosure. __$200,000__5. Enter your adjusted basis in the property.(Usually your purchase price plus the cost of any major improvements.) ___$170,000__6. Subtract line 5 from line 4.If less than zero, enter zero.___$30,000__
The amount on line 6 is your gain from the foreclosure of your home. If you have owned and used the home as your principal residence for periods totaling at least two years during the five year period ending on the date of the foreclosure, you may exclude up to $250,000 (up to $500,000 for married couples filing a joint return) from income. If you do not qualify for this exclusion, or your gain exceeds $250,000 ($500,000 for married couples filing a joint return), report the taxable amount on Schedule D, Capital Gains and Losses.
The amount on line 6 is your gain from the foreclosure of your home. If you have owned and used the home as your principal residence for periods totaling at least two years during the five year period ending on the date of the foreclosure, you may exclude up to $250,000 (up to $500,000 for married couples filing a joint return) from income. If you do not qualify for this exclusion, or your gain exceeds $250,000 ($500,000 for married couples filing a joint return), report the taxable amount on Schedule D, Capital Gains and Losses.
In this situation, the borrower has a tax-free home-sale gain of $30,000 ($200,000 minus $170,000), because they owned and lived in their home as a principal residence for at least two years. Ordinarily, the borrower would also have taxable debt-forgiveness income of $20,000 ($220,000 minus $200,000). But since the borrower’s liabilities exceed assets by $20,000 ($250,000 minus $230,000) there is no tax on the canceled debt.
Other examples can be found in IRS Publication 544, Sales and Other Dispositions of Assets, under the section “Foreclosures and Repossessions”.
6. I don’t agree with the information on the Form 1099-C. What should I do?
Contact the lender. The lender should issue a corrected form if the information is determined to be incorrect. Retain all records related to the purchase of your home and all related debt.
7. I received a notice from the IRS on this. What should I do?
The IRS urges borrowers with questions to call the phone number shown on the notice. The IRS also urges borrowers who wind up owing additional tax and are unable to pay it in full to use the installment agreement form, normally included with the notice, to request a payment agreement with the agency.
8. Where else can I go to get tax help?
If you are having difficulty resolving a tax problem (such as one involving an IRS bill, letter or notice) through normal IRS channels, the Taxpayer Advocate Service may be able to help. For more information, you can also call the TAS toll-free case intake line at 1-877-777-4778, TTY/TDD 1-800-829-4059.
In some cases, you may qualify for free or low-cost assistance from a Low Income Taxpayer Clinic (LITC). LITCs are independent organizations that represent low income taxpayers in tax disputes with the IRS. Find information on an LITCs in your area.
Related Items:
Publication 523, Selling Your Home
Publication 544, Sales and Other Dispositions of Assets
Publication 908, Bankruptcy Tax Guide
Form 1040, U.S. Individual Income Tax Return
Form 1040, Schedule D, Capital Gains and Losses
Form 1099-C, Cancellation of Debt
Form 9465, Installment Agreement Request
Canceled Debts, Foreclosures, Repossessions, and Abandonments
A summary of Publication 4681
By Stacie Clifford Kitts, CPA
Generally
Generally, if you have a debt (that is a debt that you are personally liable for) that is cancelled or forgiven, you must include the amount of cancelled debt as ordinary income on your income tax return. However, there are exceptions to this rule. Here is a list of some of the exceptions which would allow you to exclude the cancelled debt from income:
1) If the cancellation is intended to be a gift, then you are not required to report it as income. See Publication 525 for more information.
2) Certain student loans, if they contain a provision that the debt can be cancelled if certain qualifications are met.
3) If payments on the debt would have been considered tax deductions at the time the principal payments were made.
4) If the price of an item you have purchased on credit is reduced by the seller at a time when you are insolvent. However, you must reduce your basis in the property by the amount of the reduction.
There are also certain situation which allow you to exclude debt cancelation from income.
Bankruptcy
If you are bankrupt and you file for bankruptcy under title 11, the debt that is cancelled is not included in your income. But only if the cancellation of debt is under the jurisdiction of a court and the court approves the cancelation.
If your debt is cancelled, you should complete and attach Form 982 to your federal income tax return.
Insolvency
You are not required to include debt cancellation to the extent that you are insolvent immediately before the cancellation. You are insolvent if the total of your liabilities, exceeds the FMV of all of your assets.
To show that you are insolvent and to exclude cancelled debt, attach Form 982 to your income tax return.
The following worksheet can be used to calculate the extent that you were insolvent.
[Click on the picture to enlarge]
Certain qualified farm indebtedness can be excluded from income – See publication 4681
Qualified Real Property Business Indebtedness
If you have qualified real property business indebtedness that is cancelled, you can elect to exclude this from income. However, the debt must meet the following criteria:
1) It must be incurred or assumed in connection with real property used in a trade or business.
2) It must be secured by such real property.
3) It must be incurred or assumed at either of the following times:
a. Before 1993
b. After 1992, if the debt is either (i) qualified acquisition indebtedness (defined below), or (ii) debt incurred to refinance qualified real property business debt incurred or assumed before 1993 ( but only to the extend the amount of such debt does not exceed the amount of debt being refinanced.)
4) It must be debt to which you elect to apply these rules
Qualified principal Residence indebtedness
The qualified debt from your principal residence can be excluded from income if it is cancelled. The maximum amount that can be excluded is $2 million ($1 million if you are married filing separately).
Be sure to check out Publication 4681 for a definition of qualified principal residence indebtedness.
Attach a completed Form 982 to your federal income tax return to exclude the income.
Qualified Midwestern Disaster Area Indebtedness
If non business debt is cancelled by an applicable entity and you are a qualified individual you can exclude the cancelation from income. See publication 4681 for more details.
What’s new for 2008
The qualified principle residence indebtedness exclusion has been extended. The extension includes debts discharged after 2006 and before 2013.
The Heartland Disaster Tax Act Relief of 2008 which allows qualified individual to exclude from gross income discharges of certain indebtedness because of Midwestern Disasters.
The American Recovery and Reinvestment Act of 2009 allows certain businesses to make an elect to defer over a five year period the recognition of income from the cancellation of business debt arising from the reacquisition of certain types of business debt repurchased in 2009 or 2010. However, for the current or subsequent years, if you make the election to defer over the five year period, you cannot exclude the cancellation of debt related to a title 11 bankruptcy case, insolvency, qualified farm indebtedness or qualified real property business indebtedness. See Section 108(i) for more information.
Stacie's Tax Stuff 
