First of two parts: Tax relief available, but many factors dictate how much

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An unfortunate event in this economic crisis is the increase in short sales and foreclosures of homes.

In general, a short sale is a sale by an owner in which the amount owed on the property is greater than the amount the seller will realize from the sale. The seller must obtain an agreement from the lender that the proceeds from the sale will satisfy the debt in full in order to convey clear title to the property to the buyer.

A foreclosure or a deed in lieu of foreclosure results in the repossession of a property by the lender due to default on the loan on the part of the borrower.

Each of these events can carry significant tax consequences unless the borrower meets certain exclusions.

With either a short sale or a foreclosure, two distinct, potentially taxable events can occur. These include: (1) income resulting from the forgiveness of the debt is realized by the homeowner and (2) gain or loss resulting from the sale of the residence to a third party or deemed sale of the residence to the lender in satisfaction of the debt must also be considered.

The Mortgage Debt Foregiveness Act of 2007 and the Emergency Economic Stabilization Act of 2009 provide tax relief for debt forgiven through a short sale, foreclosure or deed in lieu of foreclosure on a principal residence.

Generally, to qualify as a taxpayer’s principal residence, the taxpayer must own and use the property as his or her  primary residence for periods totaling two out of five years before the sale.  Under Internal Revenue Code Section 108, the discharge of qualified debt incurred to buy, construct or substantially improve a principal residence can be excluded from income if the discharge occurs in calendar years 2007 through 2012. The residence must secure the debt. Up to $2 million of forgiven debt is eligible for this exclusion for married couples filing joint tax returns.

If the taxpayer does not meet the Principal Residence Debt Exclusion under the Mortgage Debt Forgiveness Act of 2007 or the Emergency Economic Stabilization Act of 2009 discussed above, they must look to other provisions for possible tax relief.

Recourse versus nonrecourse

The first step is to determine if the debt is “recourse” or “nonrecourse.” If the debt is recourse, the borrower is personally liable for the debt and the lender is able to pursue the borrower’s other assets in satisfaction of the debt.

If the debt is nonrecourse, the lender’s remedy is limited to the property and the borrower is not personally liable for any deficiency. In California, most loans incurred to purchase a home are nonrecourse. Mortgages from refinancing a previous mortgage or home equity line of credit are typically recourse.

Cancellation of indebtedness

The second step is to determine if a taxpayer has cancellation of indebtedness (COI) income. When a property subject to nonrecourse debt is foreclosed on or is sold subject to a short sale, the property is treated as being sold for the balance of the mortgage. Therefore, there is no COI income.

For property subject to a recourse loan, COI income is the difference between the principal balance of the debt and the fair market value of the property securing the debt.

There are specific exceptions to this, including the Principal Residence Debt Exclusion, which blurs the distinction between recourse and nonrecourse debt in determining the type and amount of discharged debt eligible for favorable tax treatment.

Gain or loss on sale

The third step is to determine the gain or loss on the sale of the property.

Short sales, foreclosures and deeds in lieu of foreclosure are treated as sales or deemed sales for tax purposes.

The gain or loss is determined by subtracting the net sales price of the property from the owner’s adjusted basis in the property.

The adjusted basis of the property is generally equal to the purchase price plus costs to acquire the property and improvement costs less any depreciation taken.

The selling price is equal to the outstanding principal balance of the loan in the case of nonrecourse debt and the price that a third party would pay for the property if the loan is recourse, less any transaction expenses related to the sale.

This article focuses on the income tax aspects of foreclosures and short sales involving principal residences and other personal property. The rules dealing with debt restructurings and foreclosures involving business and rental real estate will be covered in a future article.

The above information relates only to federal income taxes under the Internal Revenue Code. SB 1055 in California was intended to make California laws more closely conform to federal legislation and was only effective for 2007 and 2008. This legislation has expired. Conformity legislation has been introduced that would adopt the same rules as provided under federal law through 2010.

But with the current budget situation in California, its enactment may be in jeopardy.

Our local economy has been heavily impacted by the tightening mortgage market and the liberal loan policies of the early to mid 2000s.

If you are involved in any form of debt restructuring or a forced sale of property, you should consult with your tax adviser to gain an understanding of how these settlements will affect your federal and California income tax returns.

It is our expectation that The Mortgage Debt Relief Act of 2007 and the Emergency Economic Stabilization Act of 2008 will provide some tax relief to those individuals having to face these difficult decisions.


Bobbi Beehler is a CPA, CFA with Pisenti & Brinker LLP and a Realtor with Coldwell Banker in Santa Rosa. She can be reached at bhoff@pbllp.com or 707-559-7303.