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Foreclosure Income? Let’s go back to Basics!

Understand the financial implications of writing-off debt...

    As the sub-prime mortgage crisis started to unfold, I was not impressed by the government’s response. “Here go the bail-outs!” my skeptical side screamed. The economists explained why it’s so important to keep those “generous” lenders out of bankruptcy while I wanted something to help property owners.

    Only a tax professional would be aware that these families would not only be possibly homeless, but they could have a big tax debt resulting from cancellation of indebtedness income! Sorry. That phrase is over the edge. Let’s get back to basics of debt cancellation income, understand it, and Congress’s solution.

    If you borrow money from a bank or mortgage company, you don’t have to pay tax on the money you receive. That’s because you have to pay it back; it’s not money you earned from working or from investing. However, if you are ultimately unable to pay back the debt, that’s another matter.

    If any part of that debt is “forgiven” or “written off” in a way that you will no longer be responsible to repay it to the lender, that amount is reportable as income on your tax return. The lender will issue you a Form 1099-C, reporting “Cancellation of Debt Income.”

    I’m not sure if “luckily” is the best description, but “luckily” there are a few situations when a person won’t have to pay tax on this Debt Cancellation Income. Debts discharged in bankruptcy are not considered taxable income. Also, if you are insolvent, though not in bankruptcy, this canceled debt will not be taxable to you to the extent of the insolvency.

    OK, what determines “insolvency”? That’s when you have more debts than you have assets; when you owe more than you own. It’s a matter of listing all you own and comparing it to the debts you owe at that time.

    My skeptic was amazed to discover Congress enacting the “Mortgage Forgiveness Debt Relief Act of 2007” for three years. It says that if you’ve been forgiven some of the mortgage on your home, your “principal residence,” it won’t be included in your taxable income. One catch: You can’t ignore more than $2 million of this home debt forgiveness. Sorry. The second catch is a real trap: the part of your mortgage that was not related to buying or improving your home cannot be excluded from income.

    That would be a problem for homeowners who rode the wave of refinancing their homes for more than the home was actually worth. Just think about calculating that fine point! If you have refinanced your home and included some payoff of credit cards and car loans, you would have to identify how much was actually for the house.

    At least we can count on some of this phantom income to be excluded from taxable income if it was our home that was in trouble. But let’s take it a bit further. There’s another piece of tax action in a foreclosure.

    When the lender takes back the property, they sell it for whatever they can get for it. They will report, on that same Form 1099-C, the amount they sold it for, calling that amount the “fair market value” of the property. Then you’d have to figure out the gain on sale of the property. The gain is the difference between the fair market value and your cost basis (the amount you actually have invested in the property).

    OK, you can breathe now. The gain figured here won’t be taxable if it’s on your principal residence and you qualify for the $250,000/$500,000 exclusion of gain from the sale of your personal residence.

    Looks like we’ll be all set, as long as we didn’t pull out much of the equity on a refinance and it’s our home that’s being foreclosed. So who has a problem now?

    It’s the person who, for example, purchased a duplex and lived in one side of it — until the rents wouldn’t cover enough of the mortgage. Their personal side would probably be ok under the two rules for homeowners: the gain exclusion on sale of personal residence and the new Mortgage Forgiveness Debt Relief. The rental half is a tax disaster! The “cancellation of debt income” would be taxable unless they are insolvent or in bankruptcy. Additionally, the “gain on sale” of that half would be taxable as the sale of a business or rental property. Ouch.

    I haven’t yet seen a lot of foreclosures among my clients in Maine, but I suppose “it” is coming. Let’s hope the economy turns around before “it” gets really bad here.

    LU BAUER, CPA is a money counselor and financial advisor in Brunswick, Maine. She is available for consultations (207-729-0531) with those who want to improve their relationship with money and better understand their business. Visit www.moneybalancingact.com for other articles helpful to individuals, families and owners.