Over the past few years, millions of Americans have faced the pain of foreclosure, and many are still navigating the frustrating process of short sales to sell their homes. Each ordeal comes with a long list of hardships, but most people ignore tax implications – until the end of tax season. The IRS rules are too complicated to rush it in April before the tax filing deadline, but help is here (and maybe some good news too).
Normally, if you default on a loan or reach a settlement for less than the full amount due, your lender will issue a 1099 tax form for the year in which the default occurred, forcing you to include the unpaid – or “forgiven” – portion of the debt as income on your tax returns. If that happens, you’d have to pay tax on “income” that never really passed through your hands. This can be extremely frustrating, not to mention tough on your budget. Depending on the size of the debt forgiven, the additional income – and the resulting tax on it – can be substantial.
Thankfully, taxes won’t necessarily undo the healing effects of your forgiven loan. In late 2007, Congress passed the Mortgage Forgiveness Debt Relief Act, providing tax relief to the millions who have been forced to settle their mortgage loans for less than the amount they owed. According to the IRS:
The Mortgage Forgiveness Debt Relief Act of 2007 generally allows taxpayers to exclude income from the discharge of debt on their principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualify for this relief. This provision applies to debt forgiven in calendar years 2007 through 2012. Up to $2 million of forgiven debt is eligible for this exclusion ($1 million if married filing separately). [emphasis added]
The act covers not only foreclosures, but also short sales or any debt settlement on your primary residence for less than the full amount owed.
How the Mortgage Forgiveness Debt Relief Act Works
While the act will help reduce your tax liability, it won’t cut down the amount of paperwork you’ll deal with. To get the tax relief, you still need to record and report the would-be income. When you settle a debt for less than it is worth, your lender should issue a Form 1099-C (Cancellation of Debt). This form reports the fair market value of your home just before the foreclosure and the amount of forgiven debt. The tax consequences of the debt forgiveness is reported and calculated on your tax return on Form 982.
You’ll need to report two potential tax consequences:
- Income from the cancellation or forgiveness of the debt
- Possible gain from the disposition of the home
To calculate the debt cancellation on a Form 982, subtract the fair market value of the home (as reported on the 1099-C, box 7) from the total amount of the debt just before the foreclosure. A number greater than zero will represent debt forgiveness income and should be carried to line 21 (other income) of page 1 of your 1040 tax form. As with most elements of the tax code, there are exclusions and exceptions, which we’ll discuss.
To calculate gain from the disposition of the home, subtract your adjusted basis in the home – what you paid for the home plus major home improvements that increase value – from the fair market value of the home at foreclosure (again, from 1099-C, line 7). If the value of the home at foreclosure is higher than your adjusted basis, you will have a gain reportable on Form 1040, Schedule D (Capital Gains and Losses).
What Isn’t Covered
Note the use of the word “generally” in the IRS explanation. It’s possibly the single most loaded word appearing in IRS regulations. And this ambiguous escape clause of a word shows up in their regulations quite frequently. In this case, it means that not all foreclosures and short sales are covered, so you need to know if the act can really help you or not.
There are two notable, significant exceptions to the act:
- Second homes and investment properties are not covered by the act. If a lender forgives your debt on either of these property types, you must report it as income. The provisions of the act apply only to your principal residence.
- Perhaps more significantly, the act holds that you can only exclude the discharge of principal residence indebtedness. That’s debt used to buy, build, or substantially improve your principal residence, or to refinance debt incurred for those purposes. Simply put, if you refinanced your home mortgage (just once or many times) and took out cash in excess of your original debt, you can’t exclude any forgiven debt from the cash-out portion of your refi. You must report it as taxable income.
For example, if last year you put took out a $180,000 mortgage on a $200,000 home and then the value rose to $250,000, you may have refinanced to get some extra cash to pay off credit cards. The difference between the original mortgage and the new value, in this case $70,000, is considered taxable income after a foreclosure or a short sale.
If the real estate market crashes and the bank forecloses on the home with a value of $190,000, then the remaining $60,000 that your lender forgave is taxable. If the house forecloses below its original value, say at $160,000, then while the $70,000 is still taxable, $20,000 of the forgiven debt (the amount below the value of your original mortgage) still falls under the act’s protection.
Similarly, home equity lines of credit and second mortgages that you may take after purchasing your home will also be excluded. But if you use the proceeds to make major improvements to your home, then that money will be protected.
Some good news: Even if you find yourself in one of the exceptions to the act, you can exclude up to $250,000 ($500,000 if married filing jointly) under the one-time exclusion of a gain on a primary residence.
If You Don’t Qualify
If you fall into one of these exceptions, or if the IRS finds another reason that their “generally” clause blocks you out, you can still find relief in other parts of the tax code.
- Bankruptcy. If your home and mortgage are included and discharged through bankruptcy, the forgiven debt is generally not taxable.
- Non-recourse Loans. In several states, home loans are “non-recourse,” which means that your lender’s remedy for default is limited to the value of the property secured by your loan. The lender may not pursue your other assets in an effort to satisfy the debt. Forgiveness of a non-recourse loan does not represent taxable income to the borrower. Mortgages are non-recourse in 12 states (AK, AZ, CA, CO, FL, ID, MN, NC, ND, TX, UT, WA), but check with your attorney to see if there are any other provisions in your community.
- Insolvency. If your total liabilities exceed your total liabilities, then you are technically “insolvent,” and forgiven debt may qualify under the insolvency exclusion. If you’re insolvent, normally the IRS won’t require you to include forgiven debts in your income. If you think you fall into this category, talk with your tax attorney. The substantiation requirements for this exclusion are considerable, and you’ll need a pro to help you prepare the paperwork.
Hopefully, a foreclosure or short sale is a once-in-a-lifetime situation, but if you’re facing the challenge of losing your home, you need to know what the tax consequences and implications are before they sneak up on you and cause more damage to your budget. Understanding the Mortgage Forgiveness Debt Relief Act might help ease some of the burden, or at least keep you from being surprised by your accountant or the IRS.
You definitely don’t want to handle the paperwork, calculations, or legal decisions on your own. Do not attempt to handle these issues on a self-prepared tax return or using free online tax preparation software. If you’re dealing with real estate debt forgiveness, you should certainly seek the guidance of a CPA, particularly if you need to use one of the methods not covered by the act.
Complete information on mortgage debt cancellation is available in IRS Publication 4681, which is currently unavailable on the IRS website. To order a copy, contact the IRS directly at (800) 829-3676 or visit an IRS field office.