HOME FORECLOSURE AND DEBT FORGIVENESS
What Every Citizen Needs to Know About Losing a Home
Executive Director, Tax Freedom Institute
The debt and credit crisis in America is causing profound financial problems for many middle-income citizens. One of the harshest ways these problems manifest themselves is with home foreclosures. Home foreclosures are up substantially over the past two years and many experts believe we may be as many as two years away from things stabilizing. In the meantime, untold thousands of people are losing their homes to foreclosure.
And to add insult to injury, the foreclosure of a home often leads to tax problems. This happens when, after foreclosure, the creditor issues Form 1099-C, Cancellation of Debt, to you and the IRS. This Form 1099-C shows that you had substantial income in the year of the foreclosure. Now the IRS wants you pay taxes on the so-called income as reported on the Form 1099-C.
Because of this, Congress fast-tracked legislation in last 2007 in order to provide relief to foreclosure victims. The bill was H.R. 3648, entitled The Mortgage Forgiveness Debt Relief Act of 2007. The act was passed by Congress and was signed by the President on December 20, 2007. It is now law and it’s discussed in this Special Report.
Why Does Foreclosure Matter?
You may ask how a home foreclosure has anything to do with one’s tax liability in the first place. Unfortunately, most people never see the connection until after the damage is done by the foreclosure.
The basic premise is that the law taxes “cancellation of indebtedness” income in most cases. Simply put, if you borrow money but later the debt is forgiven, the amount of the forgiveness is generally considered taxable income.
Does this sound crazy? Well, think about this. When you get a loan from a bank, say $50,000, you’re not taxed on the loan proceeds. You can use the money any way you like. The loan is non-taxable because you’re obligated to repay the loan. When you do repay it, you’re not entitled to any deduction for the principal amount of the loan, though you might be able to write off the interest.
But look what happens if you don’t repay the loan. In that case, you receive $50,000, which increases your wealth, without ever having to pay it back. And because you don’t have to pay it back, the nature of the transaction changes from that of loan (non-taxable) to that of “accession to wealth” which is taxable.
The Double-whammy of Home Foreclosures
The problem with home foreclosures is that the “accession to wealth” is often phantom. The reason is that all the “wealth” is tied up in the home itself, which now belongs to the bank. Also, the foreclosure always occurs at a time when the individual is the least wealthy. Otherwise, why would he lose his home to foreclosure anyway?
How the Mortgage Debt Forgiveness Act Helps
The Mortgage Debt Forgiveness Act added a provision to Internal Revenue Code section 108. That section contains the list of exceptions to the general rule saying that cancellation of indebtedness income is taxable. In fact, there are about seven or eight exceptions to the rule already listed in section 108. This new exception applies to cancellation income that arises due to a foreclosure on one’s principal residence.
The key provision of the new law states that cancellation of indebtedness income is not taxable if the indebtedness is considered “qualified principal residence indebtedness.” New code section 108(a)(1)(E). To qualify, several criteria must be met. Let’s discuss them.
- The debt must be “acquisition indebtedness.” Generally, there are two classes of home mortgage debt. The first class is debt incurred to purchase or substantially improve the property. This is called “acquisition indebtedness.” The second class is re-finance debt, which can be used for anything. The new law addresses itself only to the forgiveness of “acquisition indebtedness.” That phrase is narrowly defined as debt “incurred in acquiring, constructing, or substantially improving” one’s residence, and which debt is “secured by such residence.” See code section 163(h)(3)(B). As you can see, re-finance debt used to pay for anything other than acquiring, constructing, or substantially improving the residence is not acquisition indebtedness and is not subject to the exclusion under the new law. Such debt might include money used to pay credit cards, purchase boats or autos, take vacations, etc.
- The debt can be no more than $2 million. The new law caps the amount of debt cancellation that is not subject to taxation. That cap is $2 million.
- The debt must be secured by your “principal residence.” The phrase “principal residence” is also defined by law. Code section 121 controls. That section provides that one’s principal residence is the location where you live and occupy a home as the primary living quarters for yourself and your family. This can be a single family home, a condominium, a house trailer, etc. Think of it as your main home.
- The timing of the forgiveness. Like so many tax laws that have passed this decade, the relief provided in this law is temporary. The law provides a narrow window of time in which the relief applies. To get the benefit of this provision, the cancellation of debt must have occurred on or after January 1, 2007, and before January 1, 2010. Thus, the foreclosure must occur in that three-year window —2007, 2008 and 2009 — to be covered by this law.
How to Calculate Cancellation of Debt Income
Not all foreclosures lead to cancellation of debt income. The amount of income depends upon the debt forgiven and the fair market value (FMV) of the property at the time of the foreclosure. To determine cancellation income, simply determine the amount of debt owed immediately prior to the foreclosure then subtract from that amount the FMV of your property at the time of foreclosure. Here are some examples:
Total debt prior to foreclosure $400,000
FMV of property $400,000
Difference = cancellation income $ 0
Total debt prior to foreclosure $500,000
FMV of property $400,000
Difference = cancellation income $100,000
In Example 1, there is no cancellation of debt income but in Example 2, there is $100,000 of cancellation income. The new law will act to extinguish the tax attributable to that income.
Now the Bad News
The law contains a provision that might create a capital gains tax on the foreclosed property, while simultaneously eliminating the income tax attributable to cancellation of debt. While this might sound silly, it’s very typical of tax laws today.
The new law provides that any amount of the cancellation income not taxed because of this new exclusion must be applied “to reduce the basis of the principal residence of the taxpayer.” New code section 108(h)(1).
Consider Example 2 above. In that case, there was $100,000 of cancellation income that was not taxed because of the new law.
But the next question is, did you realize a capital gain as a result of the foreclosure? You say, “But wait. I didn’t sell my house. How can I have a capital gain?” The answer is that the tax law treats a foreclosure as a sale because a foreclosure constitutes a “disposition” of the property. '
To determine your capital gain, simply subtract your basis (the cost of acquiring the property plus all improvements) from the FMV at the time of the foreclosure. In Example 2, the property’s FMV was $400,000. Suppose that the original basis was $300,000. Look what happens under the new law.
FMV at time of foreclosure $400,000
Original basis $300,000
Required basis adjustment ($100,000)
New basis $200,000
Capital gain on foreclosure $200,000
In this example, you realize a capital gain of $200,000 on the foreclosure of the property.
Now, this may or may not be an issue, depending upon the amount of the gain and your filing status in the year of the discharge. The reason is that code section 121 excludes from income all capital gain from the sale or disposition of a principal residence, up to $250,000 for a single person and up to $500,000 for a married couple filing jointly. The exclusions in code section 121 apply to a foreclosed principal residence. Thus, in this example, there would be no capital gains tax, even though there is a substantial capital gain.
But that’s not always going to be the case. That’s why you have to carefully determine your gain and whether the section 121 exclusions apply. Even if you have a taxable capital gain, the trade off is that a capital gain is taxed at much lower rates while cancellation of debt income is taxed at the ordinary income tax rates.
Make Sure You Have Records
If you’re facing a foreclosure situation – indeed anytime there’s the chance that you’re selling or disposing of your principal residence – you have to organize your records to establish your basis. The higher the basis, the lower the gain realized on the disposition of the property.
In the case of a sale, the higher the basis, the more likely you’ll fall within one of the capital gain exclusions, depending upon your filing status. In the case of a foreclosure, the higher the basis, the less impact there will be as a result of the basis reduction rules described here.
What if the New Law Doesn’t Apply?
As I stated above, there is just a narrow window in which the relief under the new law applies. If your debt forgiveness due to a foreclosure on your home does not happen within the three years 2007, 2008 and 2009, you will not benefit from this law.
However, code section 108 contains a host of reasons why otherwise taxable cancellation of debt income may not be taxable to you. Here’s a list and brief explanation of the other statutory reasons for not taxing cancellation income:
- Cancellation due to bankruptcy. Any debt discharged under the federal bankruptcy laws is not considered taxable income.
- Cancellation while insolvent. When the debt forgiveness occurs at a time when you are insolvent, the cancellation income is not taxed. The term “insolvent” is defined by law. It means simply that the amount of your debts exceeds the total FMV of your assets. However, calculating this can be more tricky than it might appear at first glance, especially if you have a business, retirement accounts and other assets. The value of all assets must be considered as of the date of the forgiveness in answering the question whether you were insolent.
- Cancellation of qualified farm indebtedness. The law excludes from taxation any cancellation debt that arises from the forgiveness of “qualified farm indebtedness.” This is debt that arises in connection with the operation of a farming business but only if 50 percent or more of your total gross receipts for the three years prior to the year of the cancellation was from farming.
- Cancellation of qualified real property business indebtedness. If the canceled debt arose in connection with the acquisition, construction or improvement of real property used in business, the cancellation income is not taxed. However, there are certain important limitations to this relief. The chief such limitation is that an election has to be made on the tax return for the year of the cancellation to exclude the income.
- Cancellation of certain other business loans. The law also contains a general rule saying that if, a) the cancellation of debt was for a business loan, and b) the repayment of the loan would have given rise to a business deduction, the cancellation income is not taxed. To prove this, however, you must show that you did not already claim a deduction for the payment of business expenses with the cash you obtained through the loan.
- Cancellation of certain student loan debt. Federal student loan laws provide that some student loan debt can be canceled if you work in certain professions for a stated period. These can include childcare workers, special education teachers and the armed forces. There are important limitations on these rules and they must be evaluated in light of the facts and circumstances of each case.
- Other defenses to cancellation of debt income. In addition to the statutory defenses to cancellation of debt income discussed above, the courts have carved out several more factors that might constitute a defense to the claim that you had income from the cancellation of debt. Here’s a brief discussion of some key defenses.
a. The cancellation must constitute “accession to wealth.” That is, you must realize a gain from the cancellation. In the case of credit card debt, for example, much of what is canceled often includes late fees, over limit fees, penalties, etc. The cancellation of these changes is not “accession to wealth.” Thus, in the case of the cancellation of debt by a credit card company, the Form 1099-C they issue is often incorrect because it contains a host of changes that don’t constitute “accession to wealth.”
b. The canceled debt must be legal under state law. In some cases, loans are canceled that may not be perfectly legal under state law. For example, loans to minors, or loans that are in violation of state usury laws are examples. Any loan that is not fully enforceable under state law cannot be subject to cancellation income.
c. Debts canceled as a gift or bequest. Two of the most common non-statutory exceptions are the cancellation of debt that comes in the form of a gift or bequest from a decedent. Suppose your uncle loaned you $20,000 to go to school. Then, as a graduation gift, he forgives the debt. This is not income. It’s a gift. Likewise, if your uncle dies and in his will forgives the debt. That is an inheritance to you. It’s not income.
d. Cancellation of disputed amount. When there is a legitimate dispute as to what you owe, and the creditor reduces the amount as a means of settlement, the reduction is not income to you. The dispute must be based upon the charges for goods purchased or services rendered. The dispute cannot be based upon ability to pay.
e. Dormant debts are not canceled. Often, creditors will put delinquent debts in a “dormant,” “inactive,” “suspense,” or other frozen state in which no collection efforts are pursued. However, the debt is not actually written off. In order for there to be cancellation income, the debt must be physically written off the creditor’s books. The IRS’s regulations state that there must be a clearly “identifiable event” which establishes that the creditor in fact forgave the loan. Merely freezing collection, for however long a creditor chooses to do so, is not such an event.
The mere issuance by the creditor of Form 1099-C does not necessarily constitute an “identifiable event.” This is especially true when you have expressed to the creditor a willingness to resolve the issues, negotiate new payments, or the intent to pay the debt.
You Have the Burden of Proof
In a debt forgiveness situation, the burden of proof is on you to show that one or more of the many exceptions discussed here apply to you. You will need records to support your claim and you’ll need to argue that a specific exemption applies.
The context in which you make the argument will depend upon the posture of the case. You may assert your defense on the 1040 Form at the time of filing by using IRS Form 8275 to explain why the cancellation income is not taxable.
You have the right to challenge an IRS determination of taxability. This can be done through the IRS’s Office of Appeals and if necessary, the United States Tax Court. More details are available on exercising these rights in my books, IRS,Taxes and the Beast, and the Taxpayers’ Defense Manual.
Make Sure You Consult Counsel
If you've been through a home foreclosure or had a deb cancelled by a creditor, be sure you consult counsel on how best to deal with the Form 1099-C that you'll be facing. One way to get the personal help you need is to become a member of my Tax Solutions Network. You’ll receive valuable benefits as a member, including a thorough evaluation of your situation and written plan of action to resolve your problem. For more information, you can call my office at 800-346-6829.
You can also contact the Tax Freedom Institute member nearest you for help with your case. The Tax Freedom Institute is a national association of attorneys, accountants and enrolled agent who practice in the area of taxpayers’ rights issues and IRS problems resolution.
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