Some tax time info…

HUGE (and obvious) disclaimer right up front…I AM NOT AN ACCOUNTANT OR TAX ATTORNEY…CONTACT THE APPROPRIATE PROFESSIONAL FOR ANY AND ALL TAX ADVICE.

Ok..now that we have that out of the way…below I’ll answer a few of the most common questions I get from my short sale clients regarding the Mortgage Forgiveness Debt Relief Act.

The Mortgage Forgiveness Debt Relief Act 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, may qualify for this relief.

The amount excluded reduces the taxpayer’s cost basis in the home. More details. Further information, including detailed examples, can also be found in Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments.

The questions and answers, below, are based on the law prior to the passage of the Mortgage Forgiveness Debt Relief Act.

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 and then forgives that balance, 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. (FLORIDA IS NOT a non-recourse state for residential mortgages)

3. I lost my home through foreclosure.  Are there tax consequences? 

• There MAY be a Taxable cancellation of debt 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 generally taxable unless you meet one of the exceptions in question 2.

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.  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.  Always retain all records related to the purchase and sale (or foreclosure) of your home and all related debt.

6. 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.

7. Where else can I go to get tax help?

If you are having difficulty resolving a tax problem (such as one involving an IRS bill, letter or notice) through normal IRS channels, the Taxpayer Advocate Service may be able to help. For more information, you can also call the TAS toll-free case intake line at 1-877-777-4778, TTY/TDD 1-800-829-4059.

In some cases, you may qualify for free or low-cost assistance from a Low Income Taxpayer Clinic (LITC).  LITCs are independent organizations that represent low income taxpayers in tax disputes with the IRS. Find information on an LITCs in your area.

Related Items:

• Publication 523, Selling Your Home

• Publication 544, Sales and Other Dispositions of Assets

• Publication 908, Bankruptcy Tax Guide

• Form 1040, U.S. Individual Income Tax Return

• Form 1040, Schedule D, Capital Gains and Losses

• Form 1099-C, Cancellation of Debt

• Form 9465, Installment Agreement Request