Deficiency
Judgment
Short Sale Tax Relief
IR-2007-159, Sept. 17, 2007
WASHINGTON — The Internal
Revenue Service unveiled a special new section today on IRS.gov for people who
have lost their homes due to foreclosure. The IRS also reassured homeowners
that, although mortgage workouts and foreclosures can have tax consequences,
special relief provisions can often reduce or eliminate the tax bite for
financially strapped borrowers who lose their homes.
The new section of IRS.gov
includes a variety of information, including a worksheet designed to help
borrowers determine whether any of the foreclosure-related relief provisions
apply to them. For those taxpayers who find they owe additional tax, it also
includes a form they can use to request a payment agreement with the
IRS. . In some cases, eligible taxpayers may qualify to settle their tax
debt for less than the full amount due using an offer-in-compromise.
The IRS urges struggling
homeowners to consider their options carefully before giving up their
homes through foreclosure.
Under the tax law, if
the debt wiped out through foreclosure exceeds the value of the property,
the difference is normally taxable income. But a special rule allows
insolvent borrowers to offset that income to the extent their liabilities
exceed their assets.
The IRS cautions that under
the law, relief may be limited or unavailable in some situations where, for
example, part or all of a home was ever used for business or rented out.
Borrowers whose debt is
reduced or eliminated receive a year-end statement (Form 1099-C) from their
lender. By law, this form must show the amount of debt forgiven and the
fair market value of property given up through foreclosure. Though the winning
bid at a foreclosure auction is normally a property’s fair market value, it may
not necessarily reflect its true value in some cases.
The IRS urges borrowers to
check the Form 1099-C carefully. They should notify the lender immediately if
any of the information shown on their form is incorrect. Borrowers should pay
particular attention to the amount of debt forgiven (Box 2) and the value
listed for their home (Box 7).
The IRS also reminds
lenders of their obligation to provide accurate information on the Form 1099-C.
By law, the lender must send a copy of this form to the IRS. IRS
follow-up contacts with taxpayers involved in foreclosure are based largely on
the information reported on this form, and whether it conflicts with
information provided by the taxpayer on their federal income tax return.
The IRS normally initiates
these follow-up contacts by sending the borrower a notice. The tax
agency urges borrowers with questions to call the phone number shown on the
notice. The IRS also urges borrowers who wind up owing additional
tax and are unable to pay it in full to use the installment agreement
form, normally included with the notice, to request a payment agreement
with the agency.
Questions and Answers on Home
Foreclosure and Debt Cancellation
1.
What is Cancellation of Debt?
If you borrow money from a
commercial lender and the lender later cancels or forgives the debt, you may
have to include the cancelled amount in income for tax purposes, depending on
the circumstances. When you borrowed the money you were not required to include
the loan proceeds in income because you had an obligation to repay the lender.
When that obligation is subsequently forgiven, the amount you received as loan
proceeds is reportable as income because you no longer have an obligation to repay
the lender. The lender is usually required to report the amount of the canceled
debt to you and the IRS on a Form 1099-C, Cancellation of Debt.
Here’s a very simplified
example. You borrow $10,000 and default on the loan after paying back $2,000.
If the lender is unable to collect the remaining debt from you, there is a
cancellation of debt of $8,000, which generally is taxable income to you.
2.
Is Cancellation of Debt income always taxable?
Not always. There are
some exceptions. The most common situations when cancellation of debt
income is not taxable involve:
- Bankruptcy: Debts discharged through bankruptcy are not
considered taxable income.
- Insolvency: If you are insolvent when the debt is
cancelled, some or all of the cancelled debt may not be taxable to you.
You are insolvent when your total debts are more than the fair market
value of your total assets. Insolvency can be fairly complex to determine
and the assistance of a tax professional is recommended if you believe you
qualify for this exception.
- Certain farm debts: If you incurred the debt directly
in operation of a farm, more than half your income from the prior three
years was from farming, and the loan was owed to a person or agency
regularly engaged in lending, your cancelled debt is generally not
considered taxable income. The rules applicable to farmers are complex and
the assistance of a tax professional is recommended if you believe you
qualify for this exception.
- Non-recourse loans: A non-recourse loan is a loan for
which the lender’s only remedy in case of default is to repossess the
property being financed or used as collateral. That is, the lender cannot
pursue you personally in case of default. Forgiveness of a non-recourse
loan resulting from a foreclosure does not result in cancellation of debt
income. However, it may result in other tax consequences, as discussed in
Question 3 below.
3. I
lost my home through foreclosure. Are there tax consequences?
There are two possible
consequences you must consider:
- Taxable cancellation of debt income. (Note: As stated
above, cancellation of debt income is not taxable in the case of
non-recourse loans.)
- A reportable gain from the disposition of the home
(because foreclosures are treated like sales for tax purposes). (Note:
Often some or all of the gain from the sale of a personal residence
qualifies for exclusion from income.)
Use the following steps to
compute the income to be reported from a foreclosure:
Step 1 - Figuring Cancellation of
Debt Income (Note: For non-recourse loans, skip this
section. You have no income from cancellation of debt.)
1. Enter the total amount
of the debt immediately prior to the foreclosure.___________
2. Enter the fair market
value of the property from Form 1099-C, box 7. ___________
3. Subtract line 2 from line
1.If less than zero, enter zero.___________
The amount on line 3 will
generally equal the amount shown in box 2 of Form 1099-C. This amount is
taxable unless you meet one of the exceptions in question 2. Enter it on
line 21, Other Income, of your Form 1040.
Step 2 – Figuring Gain from
Foreclosure
4. Enter the fair market
value of the property foreclosed. For non-recourse loans, enter the amount of
the debt immediately prior to the foreclosure
5. Enter
your adjusted basis in the property. (Usually your purchase price plus the cost
of any major
improvements.)
6. Subtract line 5 from
line 4. If less than zero, enter zero.
The amount on line 6 is
your gain from the foreclosure of your home. If you have owned and used
the home as your principal residence for periods totaling at least two years
during the five year period ending on the date of the foreclosure, you may
exclude up to $250,000 (up to $500,000 for married couples filing a joint
return) from income. If you do not qualify for this exclusion, or your
gain exceeds $250,000 ($500,000 for married couples filing a joint return),
report the taxable amount on Schedule D, Capital Gains and Losses.
4. I
lost money on the foreclosure of my home. Can I claim a loss on my tax
return?
No. Losses from the
sale or foreclosure of personal property are not deductible.
5.
Can you provide examples?
A borrower bought
a home in August 2005 and lived in it until it was taken through
foreclosure in September 2007. The original purchase price was $170,000, the
home is worth $200,000 at foreclosure, and the mortgage debt canceled at
foreclosure is $220,000. At the time of the foreclosure, the borrower is
insolvent, with liabilities (mortgage, credit cards, car loans and other debts)
totaling $250,000 and assets totaling $230,000.
The borrower figures income
from the foreclosure as follows:
Use the following steps to
compute the income to be reported from a foreclosure:
Step 1 - Figuring Cancellation of
Debt Income (Note: For non-recourse loans, skip this
section. You have no income from cancellation of debt.)
1. Enter the total amount
of the debt immediately prior to the foreclosure. $220,000
2. Enter the fair market
value of the property from Form 1099-C, box 7. $200,000
3. Subtract line 2 from
line 1.If less than zero, enter zero. $20,000
The amount on line 3 will
generally equal the amount shown in box 2 of Form 1099-C. This amount is
taxable unless you meet one of the exceptions in question 2. Enter it on
line 21, Other Income, of your Form 1040.
Step 2 – Figuring
Gain from Foreclosure
4. Enter the fair market
value of the property foreclosed. For non-recourse loans, enter the amount of
the debt immediately prior to the foreclosure. $200,000
5. Enter your
adjusted basis in the property. (Usually your purchase price plus the cost of
any major improvements.) $170,000
6. Subtract line 5 from
line 4.If less than zero, enter zero. $30,000
The amount on line 6 is
your gain from the foreclosure of your home. If you have owned and used
the home as your principal residence for periods totaling at least two years
during the five year period ending on the date of the foreclosure, you may
exclude up to $250,000 (up to $500,000 for married couples filing a joint
return) from income. If you do not qualify for this exclusion, or your
gain exceeds $250,000 ($500,000 for married couples filing a joint return),
report the taxable amount on Schedule D, Capital Gains and Losses.
In this situation, the
borrower has a tax-free home-sale gain of $30,000 ($200,000 minus $170,000),
because they owned and lived in their home as a principal residence for at
least two years. Ordinarily, the borrower would also have taxable
debt-forgiveness income of $20,000 ($220,000 minus $200,000). But since the
borrower’s liabilities exceed assets by $20,000 ($250,000 minus $230,000)
there is no tax on the canceled debt.
Other examples can be found
in IRS Publication 544, Sales and Other Dispositions of Assets, under the
section “Foreclosures and Repossessions”.
6. I
don’t agree with the information on the Form 1099-C. What should I do?
Contact the lender.
The lender should issue a corrected form if the information is determined to be
incorrect. Retain all records related to the purchase of your home and
all related debt.
7.
I received a notice from the IRS on this. What should I do?
The IRS urges borrowers
with questions to call the phone number shown on the notice. The IRS also urges
borrowers who wind up owing additional tax and are unable to pay it in full to
use the installment agreement form, normally included with the notice,
to request a payment agreement with the agency.
This information is made
available on this website as a courtesy to the American taxpayer, from public
information made available by the Internal Revenue Service.
