If you are one of the unfortunate valley residents who purchased a home during the real estate boom only to watch its value plummet when the bubble burst, you’ve likely considered seeking out a mortgage modification with your lender, imploring the bank to reduce a portion of your principal balance. Or perhaps things have gotten so bad that you’re contemplating pursuing a foreclosure or short sale.
But be warned: These steps carry tax consequences. For example, when a lender forgives a portion of a principal balance of a mortgage, the borrower is required to recognize cancellation of indebtedness income to the extent of the forgiven debt.
Similarly, if a property is sold at foreclosure or in a short sale and the underlying mortgage is recourse (meaning the borrower has personal responsibility for any excess loan deficiency remaining after the sale, as is typically the case with home mortgages in Colorado), the transaction can generate two different types of taxable income. First, the borrower must recognize gain or loss for the difference between the sales price of the home and the borrower’s basis in the home (what they paid for it plus improvements). Next, because the sales price of the home is generally not enough to fully repay the lender, if the lender agrees to forgive the remaining deficiency, the borrower must recognize cancellation of indebtedness income to the extent of the forgiven loan balance.
In the foreclosure or short sale context, any gain resulting from the sale of a principal residence in a foreclosure or short sale is generally not problematic, as the tax law permits married taxpayers to exclude up to $500,000 of gain — and single taxpayers up to $250,000 — on the sale of a home, provided the taxpayers have owned and used the home as their principal residence for two of the prior five years.
Any cancellation of indebtedness income, however, whether resulting from a debt modification or the forgiveness of a remaining deficiency after a foreclosure or short sale, is not treated as gain from the sale of a home, and thus may not be excluded under the provision previously discussed. As a result, barring some sort of statutory relief, cancellation of indebtedness income must generally be included in your taxable income.
Example: Adam owns a primary residence with a basis of $800,000 that is subject to a recourse mortgage with a balance of $600,000. The property declines in value to $500,000, at which point the lender agrees to allow Adam to enter into a short sale. He sells the home to an unrelated buyer, Brad, for $500,000. Adam remits the $500,000 sales price to the lender in settlement of the $600,000 debt, leaving Adam with a $100,000 remaining deficiency, which the lender forgives.
On the sale of the home, Adam recognizes a $300,000 loss ($500,000 sales price less $800,000 basis). Adam may not deduct this loss on his tax return, as losses from the sale of a personal residence are considered nondeductible personal losses.
In addition, Adam recognizes $100,000 of cancellation of indebtedness income resulting from the lender’s forgiveness of the remaining deficiency ($600,000 loan balance less $500,000 received from the sale.) This $100,000 must be included in Adam’s taxable income unless a statutory exception applies.
The law has long contained exceptions to cancellation of indebtedness income for taxpayers who are either bankrupt or insolvent at the time the debt was forgiven. After the real estate market and economy simultaneously crashed in 2007, however, Congress recognized that relief was necessary even for those taxpayers who weren’t formally bankrupt or mathematically insolvent, as it seemed patently unfair to tax homeowners on cancellation of indebtedness income when they couldn’t even afford to service the mortgage on the underlying property.
To rectify this inequity, Congress enacted a temporary provision that allows a taxpayer who is neither insolvent nor in bankruptcy to exclude up to $2 million of cancellation of indebtedness income related to the discharge (in whole or in part) of a mortgage on the taxpayer’s primary residence. This exclusion applies whether the taxpayer simply negotiates a reduction in the principal balance of his mortgage or disposes of his principal residence in a foreclosure or short sale.
In order to utilize this exception, several requirements must be met:
• The home must be the taxpayer’s principal residence; the exclusion does not apply to second homes or vacation homes. To meet this standard, the home must have been owned and used by the taxpayer as their principal residence for two of the previous five years.
• The forgiven mortgage debt must have been used to acquire, construct, or improve the home. As previously mentioned, the taxpayer may exclude from income up to $2 million of forgiven debt ($1 million for married taxpayers who file separately).
• Refinanced debt qualifies, but only to the extent the refinancing does not exceed the amount of the original acquisition debt.
• To the extent any cancellation of indebtedness income is excluded under this provision and the taxpayer remains the owner of the property (for example, in a modification), the taxpayer must reduce their basis in the home.
This temporary exclusion briefly expired on Dec. 31, 2012 before being resuscitated for 2013 by the fiscal cliff negotiations. This means that for the remainder of this year, you can continue to exclude from taxable income up to $2 million of forgiven debt on your principal residence even if you are not insolvent or bankrupt. Beyond 2013, however, the fate of this temporary exclusion remains unknown.
So ask yourself this: How much do you trust Congress to extend this provision into 2014? Because if you don’t — and you probably shouldn’t —then now is the time to meet with your lender if you have been pondering a debt modification, foreclosure, or short sale, so you may benefit from this exclusion while it still exists.
Tony J. Nitti, CPA, MST, can be reached at firstname.lastname@example.org .