Foreclosures, Short Sales, And Mortgage Restructuring: Out Of The Frying Pan, Into The Fire? You Are Creating A Tax Problem For Yourself.

Posted by: John DeLancett
April 06, 2009
Topic: Legal News

Foreclosures, Short Sales, And Mortgage Restructuring: Out Of The Frying Pan, Into The Fire? You Are Creating A Tax Problem For Yourself.

A little known provision of the Internal Revenue Code, section 108, provides that, whenever there is a discharge of indebtedness, a Taxpayer may have to recognize income. When a Taxpayer borrows money, he does not report the sums received as income in that taxable year. As long as he repays the debt, there is never an income tax liability assessed upon the proceeds of the loan. However, if a Taxpayer fails to repay the full amount of the debt, he may suffer a number of tax consequences ranging from reduction of basis on the real property to actual tax liabilities.

The severe economic downturn of the past few years has, as everyone knows, resulted in substantial depreciation of residential real estate. As a result, a number of Homeowners have discovered that they owe more on their property than the property is currently worth. This poses serious issues when they are no longer able to pay their mortgages and the property can not be sold for enough money to pay off the mortgage. This can result in potential liability for a deficiency judgment (the difference between the amount of the court judgment and the amount for which the property sells at a foreclosure sale) and can also result in income tax issues arising from the discharge of the additional indebtedness, that is the difference between the value of the property and the amount of the debt.

Recognizing the severe problem created by the recent decline in the value of real property, Congress acted in 2007 by adopting the Mortgage Forgiveness Debt Relief Act. Provisions of the act exclude discharge of indebtedness income to a Taxpayer resulting from a "Qualified Principal Residence Indebtedness". Acquisition indebtedness, as defined in IRC §163(h)(3)(B), which generally means indebtedness incurred in the acquisition, construction or substantial improvement of a principal residence that is secured by that residence. It can also include refinancing of that indebtedness to the extent that the refinancing does not exceed the amount of the previous indebtedness. The term "Principal Residence" has the same meaning as under §121 of the Internal Revenue Code.  Accordingly, as long as a Taxpayer is dealing with his principal residence, he should not suffer any discharge of indebtedness income as a result of a foreclosure, short sale, or debt restructuring which results in the Taxpayer owing less than the full amount of the debt secured by his principal residence. Since this law only applies to a Taxpayer's principal residence, it will not avoid discharge of indebtedness income as to investment or commercial property. There may be circumstances where there is additional debt on the principal residence that is not acquisition indebtedness. For example, assume a Taxpayer has a $500,000.00 first mortgage on his principal residence which he obtained to be able to purchase it. Subsequent thereto, he withdraws another $150,000.00 on an equity line of credit. The house is subsequently foreclosed upon and sells for $450,000.00. Only $50,000.00 of the amount discharged will be excluded from his income.

However, the Taxpayer's basis in the principal residence is still reduced by the amount excluded from income under the bill. This can be important in determining any gain on a deemed sale of the property. The law also does not apply to a Taxpayer in a Chapter 11 case, nor does it apply if the discharge is on account of services that were performed for the lender, or any other factor not directly related to a decline in the value of the residence or the financial condition of the Taxpayer. The provision was initially effective for discharges on or after January 1, 2007. It has been extended, as of last year, to also apply to discharges occurring after January 1, 2010, and before January 1, 2013.

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