Tax Consequence for the Borrower from Foreclosure Proceedings

What is the income tax consequence for the borrower from a short sale or deed in lieu? This is a question frequently asked by borrowers facing foreclosure. Income tax may be imposed for a cancellation of a debt (“COD”) before Bush signed Foreclosure Tax Relief Bill into law.

Dec 20, 2007, President Bush signed Foreclosure Tax Relief Bill into law. The bill provides tax relief for homeowners facing foreclosure or bankruptcy. The bill eliminates federal taxes due from homeowners who have had mortgage debt forgiven as part of a foreclosure or the renegotiation of a loan. Before this law becomes effective, such debt forgiveness had been treated as taxable income. If your home is a primary residence, you will be covered by this law now.

Based on my research, even before this bill was singed into law, you might or might not have the tax consequences depending on whether your property is a primary residence or investment property and whether your short sale or deed in lieu results in COD gain or loss. Here is why.

Let’s start with COD gain and loss.

First of all, a short sale, deed in lieu, or even the foreclosure sale is a real estate transaction. Often in this situation the borrower transfers the house to the lender as in deed in lieu or to a third party as in short sale. This transfer is treated as a sale or other disposition of the property and results in the borrower realizing gain or loss. At the time of the transfer, the lender often cancels the remaining mortgage debt, leading to COD income.

If the debt is cancelled in part or full in a foreclosure proceeding, you will have COD income. This COD income is equal to the difference between the unpaid amount of the debt and the fair market value (FMV) of the property you transfer to the lender or a third party to discharge that debt. For example, if your debt prior to foreclosure was $210,000 and the FMV of the property was $180,000, you would have $30,000 of COD income. That is, you have $30,000 gain.

However, you may not have COD income under following circumstances:

1. Your lender does not cancel your remaining unpaid portion of debt after your house is transferred to the lender by foreclosure. This could happen if the lender believes it can still collect the balance of the debt, that is, your lender wants to file deficiency judgment on your debt. In that circumstance, you would not have COD income until the lender discharged the debt or the statute of limitations on collection of the debt expired.

2. The FMV of your house that is foreclosed upon is greater than the amount of the mortgage loan balance you owed. If the FMV is sufficient to pay the loan balance in full, the debt is satisfied and there is no COD income because no part of the debt was discharged or cancelled. For example, if the FMV of your house was $300,000, the amount of the loan balance was $240,000. If your lender granted you the deed in lieu foreclosure or your house was sold in a short sale or in the foreclosure sale in $240,000 or more. The proceeds are more than enough to satisfy the debt in full.

If the house is your principal residence, you may be able to exclude part of all of the gain under I.R.C. 121. See Publication 523, Selling Your Home. The COD gain on the foreclosure of your residence should be excluded under I.R.C. 121 and you should not be required to report the gain on your return. Therefore, based on opinion, there should not be tax consequence even without the Foreclosure Tax Relief Bill.

If your property is an investment, you should consult your account regarding the gain and loss on property foreclosure. You should also check with your accountant to see if the Foreclosure Tax Relief Bill covers investment properties.

I am not an income tax professional and not entitled to give you advices on this issue. You should always ask your accountant or attorney to explain the income tax consequences of giving property back to a mortgage lender. What I am giving here is only the information related to income tax consequence for the borrower from a short sale of deed in lieu. It should never be taken as advice. Please consult you accountant or attorney for any advice as I have always suggested.

Share This