Tax Liability of Foreclosures and Short Sales

The cancellation of debt involved in foreclosures used to lead to tax consequences, because according to the government, the debt forgiveness in a foreclosure was taxable income. In December, 2007, however, a bill was signed that eliminated the taxes on debt forgiven in a foreclosure, providing relief to homeowners.

The measure is anticipated to reduce homeowners’ taxes by $650 million and is a response to the recent increase in high-priced home loans for risky borrowers. The cost of this endeavor to the government will be offset in part by limiting a tax break available on the sale of second homes.

“Teaser” mortgage rates are increasing rapidly and this is causing many foreclosures. It is estimated that over 2 million adjustable-rate mortgages -worth some $600 billion- will jump from low initial rates to higher rates by the end of next year. These steep prepayment penalties have made it almost impossible some escape mortgages, because many homeowners cannot afford to refinance or sell their homes.

Other types of debt

While this bill does reduce the taxable income for most forgiven debt, it is still important to note that there are certain types of debt that are still considered taxable by the government. Here are some examples of forgiven debts that are still considered taxable under the bill:

Any debt forgiveness that is not related to foreclosure or short sale is still considered taxable income.

Internal Revenue Service guidelines state any debt canceled or forgiven by a commercial lender is still considered taxable.

A spokesperson from the IRS has stated that in these cases, when a debt or a portion of a debt is forgiven, the lender is required to report the canceled debt to the borrower and the IRS on a Form 1099, Cancellation of Debt. The IRS provides an 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."

Note that when money is borrowed, borrowers are not required to include the loan itself in income because they will be repaying the lender.

Bankruptcy: Debts discharged through bankruptcy are not considered taxable income.

Insolvency: If your total debts are more than the fair market value of your total assets, you are considered insolvent. In this case your forgiven loans are no longer considered nontaxable. Insolvency, however, can be fairly complex to determine and the assistance of a tax professional is recommended. Refer to IRS Form 982.

Certain farm debts: If your debt was incurred directly through operation of a farm, more than 50% of your income from the previous three years is from farming, and your loan was is through a lending agency, your canceled debt is generally not considered taxable income. These rules are complex however, and a tax professional should be consulted.

Non-recourse loans: A non-recourse loan is a loan in which, in the case of default the lender’s only option is to repossess the property being financed or used as collateral. That is, the lender cannot pursue you personally in case of default. In this case, debt forgiveness is not considered taxable, however there may be other tax consequences.

If a person loses a home through foreclosure, there are generally only two consequences: newly non-taxable cancellation of debt or a reportable gain from the disposition of the home, this is because foreclosures are treated as sales for tax purposes.

If the homeowner has owned and used the home as a principal residence for a at least two of the five years ending on the date of the foreclosure, they may exclude from income up to $250,000 or up to $500,000 for married couples filing a joint return.

If the homeowner does not qualify for this exclusion, or if their gain exceeds $250,000 (or $500,000 for married couples filing a joint return) reporting the taxable amount is required on IRS Schedule D, Capital Gains and Losses.

For more information, contact the IRS or review IRS Publication 544, Sales and Other Dispositions of Assets, under the section "Foreclosures and Repossessions."