The friendly economic environment for selling a home came to an abrupt end with the beginning of the recession in 2007. Prior to that, and in most cases, the proceeds from the sale of your home were sufficient for paying off any remaining mortgage debt. This soon became a figment of the past when homeowners engaged with banks in liberal lending practices and assumed debt at a faster pace than the increase in value of their homes. As a result, many homeowners today find themselves burdened with selling their principal residences at a loss and without enough cash to satisfy their mortgage debt. If a lender discharges any portion of the balance of a mortgage, the homeowner must report this as ordinary income. The discharged amount of the mortgage balance is considered to be cancellation of debt income (“COD”) income. Congress recognizing this undue hardship facing taxpayers, quickly responded by enacting the Mortgage Forgiveness Debt Relief Act of 2007 (the “Act”) to provide temporary relief from these unfavorable tax consequences. This article will discuss some of the more common options homeowners have when faced with a variety of these less than favorable situations.
The Internal Revenue Code (“IRC”) currently has a provision to shelter a portion of the gain from the sale of a taxpayer’s principal residence. Under IRC Section 121, a single taxpayer may exclude up to $250,000 of gain from the sale of a home and up to $500,000 if married filing jointly. The property must be the taxpayer’s principal residence for two of five years prior to sale. The Act gives “principal residence” the same meaning as in Section 121 and provides exclusion for those who may be subject to COD income.
The Act adds discharge of qualified residence indebtedness as an exception to the rule of COD income recognition.
The Act defines qualified principal residence indebtedness as acquisition indebtedness on the principal residence of up to $2 million. Acquisition indebtedness includes the debt to construct, acquire, or substantially improve the home. This also includes any refinanced acquisition indebtedness up to the amount of the mortgage prior to the refinancing. It does not include any debt that was used to acquire personal property such as an automobile or to finance other non-acquisition items. Therefore, when a discharged loan consists of both qualifying and non-qualifying indebtedness, the COD income exclusion applies only to the extent the discharged amount exceeds the non-qualifying indebtedness. In other words, there is no COD income exception for non-qualifying indebtedness.
Loan modification: If you are a homeowner and find yourself in a situation where your mortgage debt exceeds the value or the potential sale price of your home, you have several options depending upon the cooperation of your lender. Your first option is a loan modification where you may be able to reduce the principal balance of the loan to enable you to continue your mortgage payments. This debt reduction would be considered COD income, but may be excluded from income under the qualified principal residence exception as discussed above. If the homeowner retains possession of the property after the debt reduction, they must reduce the adjusted basis in the property by the amount of the excluded COD income. The income that is excluded however will eventually be realized when the property is sold. The reduction in basis may create a gain or have the effect of increasing any potential gain on the sale. The distinction between a recourse and non-recourse mortgage is ignored for purposes of loan modification as both may give rise to COD income. If the mortgage is recourse, meaning that the lender can attach the assets of the homeowner other than the secured property, then the excess may produce COD income if the lender forgives the remaining loan balance.
Generally, COD income is taxable as ordinary income. The good news is that the COD income that would have been taxable as ordinary income will now be treated as a capital gain on the sale of the property. The capital gain may be eligible for the exclusion under Section 121.
Therefore under the Act, a taxpayer who negotiates a loan modification and retains ownership of the property may be able to avoid both the recognition of COD income and the resulting capital gain from the future sale of the residence.
Short sales: Short sales are another option if a lender is not willing to modify the loan. A “short sale” refers to the sale of a home where the amount realized is less than the outstanding mortgage balance. The tax treatment of the excess of the mortgage balance less the amount realized is determined by the type of mortgage securing the property.
If the mortgage is recourse, the borrower’s amount realized does not include the debt discharge.
The COD income in this case may not be excludable under the Act, but may be excluded under other debt discharge provisions of the IRC. The COD income exclusion applies only to qualifying indebtedness, therefore COD income may be recognized for non-qualifying indebtedness that is forgiven. In the rare case where there is a gain from a short sale, when the outstanding debt is greater the basis of the property, the gain may still be excluded under Section 121.
Unlike a loan modification, a basis reduction is not required for the COD income resulting from a short sale since the taxpayer no longer owns the property.
In a short sale where there is a non-recourse mortgage (as is the case with most mortgages), the sale discharges all liability and the seller’s amount realized includes the full amount of the outstanding debt. This is true even when the outstanding debt is greater than the sales price. Therefore all gain is capital gain and there is no COD income even though the debt has been discharged. The capital gain may be excluded under Section 121.
For the homeowners that cannot arrange a loan modification or enter into a short sale, their only other course of action may be foreclosure, deed in lieu of foreclosure, and abandonment.
Foreclosure and deed in lieu of foreclosure: A foreclosure is a process by which the lender forces the sale of the home upon default of the mortgage obligation. A deed in lieu of foreclosure is a voluntary transfer of property to the lender without a sale and in full satisfaction of the debt. Both a foreclosure and a deed in lieu of foreclosure are treated as a sale for tax purposes.
The resulting tax consequences of foreclosure and deed in lieu of a disclosure are almost identical to those of a short sale.
The amount realized from the deemed sale in these cases is based on whether the transaction is a foreclosure or a deed in lieu of foreclosure and whether the loan is a recourse or non-recourse loan. In a foreclosure where the homeowner is subject to a recourse mortgage, the fair market value of the property is considered to be the amount realized, while those subject to non-recourse mortgages recognize the full amount of the outstanding debt as their amount realized. Therefore, those with a recourse mortgage will have a gain or loss equal to the difference between the fair market value of the home and the adjusted basis of the property. The assumption is that the fair market value is equal to the price they would receive if it were an actual sale unless clear and convincing evidence can be produced establishing otherwise. While gain would be unlikely in this instance, if present it would be eligible for the exclusion under Section 121. To the extent any qualified indebtedness is debt that is forgiven in the foreclosure process; this will give rise to excludable COD income. Any of the debt that is non-qualified is not subject to the COD income exclusion.
When foreclosures occur to those who are subject to non-recourse mortgages, a more likely scenario, the amount realized is deemed to be the full amount of the outstanding debt. All gain from the deemed sale of the property is treated as capital gain and eligible for the Section 121 exclusion. There is no COD income because the realized value is equal to the outstanding debt.
When a homeowner who conveys property subject to a recourse mortgage to a lender (deed in lieu of foreclosure), the property’s fair market value is used as the amount realized in the sale transaction. The IRS may establish a value if a bid price is not available. The excess of the outstanding debt over the fair market value generates COD income and is eligible for exclusion, and any gain from the sale may be excluded under Section 121. If the homeowner is subject to a non-recourse mortgage, the amount realized is the full amount of the debt and there is no COD income.
Abandonment: A homeowner’s abandonment of their property is treated in the same way for tax purposes as foreclosures and deeds in lieu of foreclosures with the exception of the timing of the transactions. When a recourse loan is involved, the COD income and any gain or loss occurs in the year of subsequent foreclosure, while the amount realized for non-recourse mortgages is realized in the year of abandonment.
Conclusion: Under current law, the provisions that extend the exclusion for COD income arising from qualified principal residence indebtedness will expire at the end of 2013. Barring any further extension, beginning in 2014, homeowners who dispose of their residence at a loss and receive discharge of recourse debt will be among the hardest hit. They face the unfortunate result of having a non-deductible loss and COD income regardless of whether the disposition is a short sale, foreclosure, deed in lieu of disclosure, or abandonment. Homeowners who opt for loan modification of a recourse or non-recourse mortgage may also be facing the prospect of COD income and increased gain from the transaction. This article does not explore every situation that is possible. If you are challenged with the issues discussed in this article, we suggest that you speak with your Marcum tax advisor to formulate a workable solution based upon your specific facts and circumstances.