What are the tax consequences if I lose my house?
06 March 2012 / Uncategorized / Comments Off on What are the tax consequences if I lose my house?
Taxation of abandonments, foreclosures and repossessions
Many individuals in the current economy have had trouble paying mortgages, car notes and other debts. Some are forced to abandon property, go through foreclosures or have property repossessed. While such measures may alleviate the financial burden on these individuals, the tax consequences often are unknown and can be very scary and stressful when it comes to tax time!
When property that secures a debt is abandoned by voluntary or involuntary action, the tax consequence depends, among other things, on whether the taxpayer was personally liable for the debt and what the property was used for.
PROPERTY SECURED BY RECOURSE DEBT (TYPICAL)
If the debtor is personally liable for the loan on the property being abandoned, the loan is a recourse debt, and until foreclosure or repossession procedures are completed, there are no tax consequences, whether the property is personal use or business use. The foreclosure or repossession is treated as a sale, and the debtor may realize a gain or loss on the deemed sale. The amount realized is the lower of the asset’s fair market value on the date of abandonment or the outstanding debt immediately before the transfer, reduced by any amount for which the taxpayer remains personally liable after the transfer. The amount realized also includes any proceeds the debtor received from the foreclosure sale. The amount realized is compared with the debtor’s basis in the property to determine gain or loss.
Gain from a foreclosure sale of abandoned property is usually includible in gross income whether or not the taxpayer used the property for business purposes. However, losses from personal-use property are nondeductible. If the property is a business-use asset, the gain or loss on disposition is either a capital or an ordinary gain or loss, depending on the character and nature of the asset. After the foreclosure has been completed, if the financial institution or creditor forgives the debtor any part of the debt, the forgiven portion is cancellation of debt (COD) income and may be includible in the debtor’s gross income. It is reported separately from any gain or loss realized from the sale.
PROPERTY SECURED BY NONRECOURSE DEBT (NOT TYPICAL)
If the debtor is not personally liable for the debt (nonrecourse debt) and abandons personal-use property, such as a home or an automobile, the abandonment is treated as a sale in the year of abandonment. The amount realized on the sale—the outstanding loan balance—is compared with the taxpayer’s adjusted basis in the property to determine gain or loss. Any loss is a nondeductible personal expense. If the property abandoned is business or investment property, the amount of gain or loss is determined in the same way. However, a loss is deductible. The character of the loss depends on the character of the property.
Generally, no COD income arises from these types of transactions because the debtor is not personally liable for the debt. However, if the debtor retains the collateral and accepts a discount from the creditor for the early payment of the debt, or agrees to a loan modification that reduces its principal balance, the amount of the discount or principal reduction is considered COD income, even if the debtor is not personally liable for the debt.
SHORT SALE
A short sale is a sale of real estate in which the proceeds from selling the property will fall short of the balance of debts secured by liens against the property and the property owner cannot afford to repay the liens' full amounts, whereby the lien holders agree to release their lien on the real estate and accept less than the amount owed on the debt. Any unpaid balance owed to the creditors is known as a deficiency. If a lender forgives the deficiency, they will send the taxpayer and the IRS a Form 1099-C reporting the amount of the deficiency forgiven. This can be a complex transaction to report for taxes as it truly represents two taxable transactions. 1) The sale of a property and 2) A cancellation of income. Both have their own tax consequences that need to be dealt with.
CANCELLATION OF DEBT INCOME
Generally, if a creditor forgives or cancels recourse debt, the amount forgiven or canceled is ordinary income to the taxpayer. The taxpayer may be able to exclude canceled debt from gross income if the debt cancellation was a gift, or in some cases if the canceled debt was a student loan, deductible debt or a price reduction after the original purchase of the property. IRC §108 also may exclude canceled debt from gross income if the taxpayer was bankrupt or insolvent immediately before the debt cancellation or if the debt is qualified farm indebtedness, qualified real property business indebtedness or qualified principal residence indebtedness.
The professionals at Widget are experts at handling real estate related issues especially in the areas of foreclosures and short-sales. Most of the time, using IRC §108, IRC §121 or reviewing your cost basis with you, we can eliminate the taxation of this type of income. Give us a call to see if we can help you!