Taxation of Foreclosures, Deeds in Lieu of Foreclosure, and Short Sales
California Association of Realtors
Member Legal Services
September 24, 2007
Introduction
It has been some time since the real estate industry, on a large scale basis, has had to deal with foreclosures, deeds in lieu of foreclosure, short sales and other distress sales of real property. Unfortunately, distress sales of real property, resulting from a convergence of tightening credit, falling property values, and the consequences of prior lending practices, are all too common currently and do not appear likely to end any time soon.
Seemingly adding insult to injury, owners of real property facing a distress sale, and generally already under financial strain, may be unpleasantly surprised to learn that two types of income can result from a foreclosure, deed in lieu of foreclosure, or short sale: capital gains, and relief of indebtedness income. Both types of income can trigger unexpected taxes for the owner.
This legal article discusses the income tax consequences to the borrower in the event of foreclosure, the event the borrower simply transfers title to the lender (deed in lieu of foreclosure), and if the borrower sells the property to another in a short sale in which a lender accepts less than the balance due on the loan as payment in full.
Q 1. Are foreclosures, deeds in lieu of foreclosure, and short sales subject to federal tax income taxation?
A Yes. However, the income is taxed differently depending on several factors, including whether there was a foreclosure, a deed in lieu of foreclosure given to the lender, or a short sale (a sale where the lender agrees to reduce the amount owed in order to facilitate a sale), and whether the underlying debt is “recourse” (the borrower is personally liable for the debt) or “nonrecourse” (the borrower is not personally liable for the debt).
For federal income taxation as a result of foreclosure, see generally 26 U.S.C. §§ 1001 through 1016. For federal income taxation of short sales, see generally 26 U.S.C. §§ 61, 108 and 1001 through 1016.
TAXATION OF FORECLOSURES OR DEEDS IN LIEU OF FORECLOSURE
Q 2. What is the difference between a foreclosure and a deed in lieu of foreclosure?
A A foreclosure refers either to a trustee’s sale foreclosure (not a judicial proceeding) or to a judicial foreclosure (a judicial proceeding). A deed in lieu of foreclosure means that the lender has agreed to accept title to the property and the borrower transfers title to the lender rather than waiting until the lender forecloses on the property. A deed in lieu of foreclosure is not a special instrument. It is simply a conveyance of the property to the lender by grant deed or quitclaim deed; and, in exchange, the lender cancels the promissory note secured by the real property. In this way the lender can avoid the foreclosure process to regain title to the property.
However, a borrower cannot simply transfer title to the lender without the lender’s permission. Because some lenders have refused to negotiate and accept the deed in lieu of foreclosure, some creative homeowners have quitclaimed the property to the lender anyway, and have recorded the instrument without the lender's permission.
In 1993, the California legislature passed a statute to protect lenders from involuntary (and invalid) transfers of real property to the lender. The lender must record a "notice of nonacceptance of a recorded deed" in the county where the real property is located. Redelivering a grant of the real property back to the original homeowner (e.g., borrower) does not legally retransfer the title. (Cal. Civ. Code § 1058.5.)
A lender may not want to take a deed in lieu of foreclosure because taking title in this manner does not extinguish any junior liens. A foreclosure by a senior lienholder essentially wipes out all junior liens.
Q 3. How does the owner receive “income” from a foreclosure or a deed in lieu of foreclosure?
A A foreclosure proceeding, whether through a trustee sale or judicial foreclosure, and a deed in lieu of foreclosure given to the lender are treated the same as a sale for income tax purposes. The foreclosure or deed in lieu of foreclosure are reported on the taxpayer’s tax return as a sale or exchange in the year the foreclosure is finalized or the deed in lieu of foreclosure is given to the lender.
In a foreclosure or deed in lieu of foreclosure, the owner can receive “capital gain or loss,” as in any other sale of real property. Additionally, the owner can receive “forgiveness of debt” income. This will depend on whether the debt is “recourse” or “nonrecourse.” If the debt is recourse debt, the owner can receive income from the amount of debt that is forgiven by the lender. If the debt is nonrecourse debt, there is no taxable income from forgiveness of debt, but there may be still be income from capital gains.
Q 4. What is “nonrecourse” debt?
A Under California law, a debt is considered “nonrecourse” when a loan is made under either one of the following two circumstances:
(1) When the loan is made to purchase a one-to-four unit property and the borrower intends to occupy at least one of the units, or
(2) When the seller carries back financing for all or a portion of the purchase price of any real property.
(Cal. Code Civ. Proc. § 580b.)
In the event of default by the borrower, the lender, or financing seller, is restricted to recovering the property with no right to proceed against the borrower for any deficiency.
Q 5. What is “recourse” debt?
A Under California law, a “recourse” debt is one in which neither of the two exemptions in Question 4 occurs.
Examples of recourse debt are refinances of existing mortgages, home improvement loans, equity lines of credit, and loans, other than seller financing, securing a debt for purchase of property that is not an owner-occupied one-to-four unit property. The lender is not limited to taking the property back and the borrower may be personally liable on the debt. If the lender chooses to foreclose using a trustee’s sale, then the lender waives the right to go after the borrower for the deficiency despite the fact that the loan was a recourse debt.
Q 6. How is the amount realized (taxable income) calculated for a “recourse” debt in a foreclosure?
A If the debt is recourse debt, meaning the owner may be personally liable for the debt, the amount realized is calculated in a two-step approach.
First, you take the difference between the fair market value (FMV) of the property and the “adjusted basis” in the property. Generally, the “adjusted basis” consists of the purchase price of the property plus any capital improvements (less depreciation, if the property is investment property). This difference is the capital gain or loss. If the amount realized exceeds the amount of the adjusted basis, then the borrower has realized a gain at the time of the transfer (foreclosure). If the adjusted basis exceeds the amount realized, then the borrower has a loss.
Second, you take the difference between the amount of the cancelled debt (e.g., unpaid loan amount) and the sales proceeds at the foreclosure (FMV). This is the forgiveness of debt income and it is treated as ordinary income. This is treated as income despite the fact that the borrower has received no cash at the time of the foreclosure.
RECOURSE DEBT
Example One:
1. The unpaid principal of the loan is $300,000;
2. The fair market value of the property is $250,000;
3. The taxpayer's adjusted basis in the property is $200,000.
Assume the lender forecloses and will forgive the underlying debt.
Step one:
FMV ($250,000) less taxpayer’s adjusted basis ($200,000) results in capital gains for the taxpayer.
FMV $250,000
Less Adjusted Basis $200,000
Capital Gains $50,000
Step two:
Amount of cancelled debt (amount owed on loan $300,000) less FMV ($250,000) is ordinary income to the taxpayer.
Amount Owed $300,000
Less FMV $250,000
Ordinary Income $50,000
Note: If a lender chooses to foreclose through a trustee's sale and is barred from obtaining a deficiency judgment by the one action rule under California Code of Civil Procedure Section 580d, it is likely the IRS will still consider that the underlying debt as a recourse debt and it will be subject to debt forgiveness income. (See Rev. Rul. 90-16.)
RECOURSE DEBT
Example Two:
If the amount realized at the foreclosure sale is more than what the lender is owed, there will be no forgiveness of debt and, thus, no ordinary income to the taxpayer.
1. The unpaid principal of the recourse debt is $300,000;
2. The fair market value of the property is $400,000;
3. The taxpayer's adjusted basis in the property is $200,000.
Step one:
FMV ($400,000) less taxpayer’s adjusted basis ($200,000) results in capital gains for the taxpayer.
FMV $400,000
Less Adjusted Basis $200,000
Capital Gains $200,000
Step two:
The debt is fully paid (since the FMV exceeds the loan amount) resulting in no forgiveness of debt income.
Q 7. How is the amount realized (taxable income) calculated for a “nonrecourse” debt in a foreclosure?
A If the debt is nonrecourse, meaning the owner is not personally liable for any deficiency (beyond the value of the property), the amount realized is the difference between the greater of the foreclosure proceeds or the entire outstanding debt and the adjusted basis of the property. This amount is treated as capital gains and there is no forgiveness of debt income
NONRECOURSE DEBT
Example:
1. The unpaid principal of the loan is $300,000;
2. The fair market value of the property is $250,000;
3. The taxpayer's adjusted basis in the property is $200,000.
Greater of foreclosure proceeds (FMV $250,000) or entire outstanding debt ($300,000) minus taxpayer’s adjusted basis ($200,000) results in capital gains to the taxpayer.
Greater of
FMV ($250,000)
OR
Outstanding Debt ($300,000)
Greater of the above $300,000
Less Adjusted Basis $200,000
Capital Gains $100,000
Q 8. How is a deed in lieu of foreclosure treated for tax purposes?
A A deed in lieu of foreclosure is treated as a sale and taxed just like a foreclosure.
See Questions 6 and 7 above.
TAXATION OF SHORT SALES
Q 9. What are the tax implications of a short sale?
A A short sale where the lender agrees to reduce some or all of the outstanding debt may give rise to forgiveness of debt income (also called "cancellation of debt" income). The amount of the debt that the lender agrees to write off is treated as ordinary income. The taxpayer will generally receive a 1099 tax form from the lender in the amount
of the debt reduction. This rule applies whether or not the underlying debt is recourse or nonrecourse.** (See Rev. Rul. 82-202, 1982 - 2 C.B. 35 and Rev. Rul. 91-31, 1991-1 C.B. 19.)
Even though the lender may be taking this action to facilitate the sale by the owner who is under a notice of default and facing a foreclosure, the agreement between the owner and the lender is considered voluntary and treated as a debt reduction.
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Although this is the majority opinion on this issue, please note that these rules are complex and there is some disagreement even among tax specialists whether the I.R.S. does, in fact, treat reduction of debt in order to facilitate a short sale on a nonrecourse loan as forgiveness of debt income.
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In addition, if the owner has owned the property for some time and has refinanced to take out some of the equity, the owner could be subject to capital gains taxation when selling the property as well. For example, the borrower has a remaining loan on the property when the borrower refinances in order to buy other investment property (or to buy a car, or to take a vacation, etc.) and now owes $300,000 to the lender. Thus, the taxpayer’s adjusted basis may be lower than the outstanding balance on the loan (as in the example below).
The tax calculation would look like step one in calculating a foreclosure sale of recourse debt.
SHORT SALE
Example:
1. The unpaid principal of the loan is $300,000;
2. The sales price (FMV) is $250,000;
3. The taxpayer's adjusted basis in the property is $50,000.
Sales price (FMV $250,000) less taxpayer’s adjusted basis ($50,000) results in capital gains for the taxpayer.
Sales Price (FMV) $250,000
Less Adjusted Basis $50,000
Capital Gains $200,000
Additionally, the taxpayer would have ordinary income from the lender’s write off of any debt, which in this example would be $50,000 (** See the discussion above in this question)
Loan Balance $300,000
Less Sales Price $250,000
Ordinary Income $50,000
TAX EXEMPTIONS
Q 10. Are there any exemptions from the relief of indebtedness income?
AYes. There are four circumstances where the taxpayer can get relief from taxation on forgiveness of debt income:
(1) The taxpayer is insolvent (the taxpayer’s debts exceed their assets as determined under Bankruptcy Code Section 108(d)(3);
(2) The debt is discharged as part of a bankruptcy proceeding;
(3) The debt discharged is qualified farm indebtedness; or
(4) The debt discharged is qualified business indebtedness (see 26 U.S.C. §108(c)).
Addtionally, The Mortgage Forgiveness Debt Relief Act of 2007 (Public Law No: 110-142) was passed in December, 2007. It provides relief to many people who have lost their home due to a short sale, foreclosure, deed in lieu of foreclosure, or any similar arrangement that relieves the borrower of the obligation to pay some portion of their debt.
The bill - an amendment to H.R. 3648 - amends the Internal Revenue Code to exclude from gross income amounts attributable to a discharge, prior to January1, 2010, of indebtedness incurred to acquire a principal residence. It reduces the basis of a principal residence by the amount of discharged indebtedness excluded from gross income. It limits to $2 million the excludable amount of such indebtedness. It also sets forth rules for determining the allowable amount of the exclusion for taxpayers with nonqualifying indebtedness and taxpayers who are insolvent.
Q 11. Are there any exemptions from the capital gains taxation in a foreclosure, deed in lieu of foreclosure or short sale if the property is a principal residence?
A Yes. If the sale, whether through a foreclosure or deed in lieu or short sale, generates capital gains and if the property was the seller’s principal residence, the seller may be able to use the capital gains exclusion of $250,000 if single and $500,000 if filing a joint return. This exclusion does not apply to the ordinary income from debt relief.
MISCELLANEOUS
Q 12. Which is better for an owner facing a distress sale: a foreclosure, a deed in lieu of foreclosure or a short sale?
A Any of these situations will impact the owner’s credit negatively. Additionally, the owner may have a significantly different tax liability depending on the disposition of the property. Consequently, this is a question that the owner needs to discuss with their own tax advisor.
Q 13. For comparison, what do the rules look like side by side?
| |
Recourse Foreclosure/
Deed in Lieu |
Nonrecourse Foreclosure/
Deed in Lieu |
Short Sale |
| Capital Gains |
FMV Less Adjusted Basis |
Greater of FMV or Outstanding Debt Less Adjusted Basis |
FMV Less Adjusted Basis |
| Ordinary Income |
Outstanding Debt Less FMV |
No Ordinary Income |
Amount of Debt Forgiven (**See the discussion in Question 9) |
Q 14. Where can readers obtain more information on the subjects covered above?
A Information is available from a variety of sources, including:
- The Internal Revenue Service (IRS) (http://www.irs.gov/), which has detailed publications available for free on many tax related subjects.
- The IRS Tele-Tax system, which is an automated voice message information system with recorded information on many commonly asked tax questions. Tele-Tax can be reached by calling 800.829.4477.
- A tax professional, such as a certified public accountant, tax attorney, or enrolled agent.
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