Forgiveness of Debt and Capital Gains on Distress Sales

Forgiveness of Debt On Short Sales & Capital Gains on Trustee Sales:

This topic is so important today because of the number of homeowners receiving Notices of Default and the value of their property is less than their loans. These people need as much information as possible when they are evaluating short sale versus foreclosure, etc. Anyone who is not a tax professional should not offer tax or legal advice. I am not giving you tax or legal advice. I am giving you sources of information that can be given to friends and associates to help them.

Just Off the Press:
The IRS homepage at www.irs.gov has a new section heading, “Questions & Answers in Home Foreclosure and Debt Cancellation”. Tell everyone about this section, it will help someone, somehow, somewhere.

A Quick Summary of Foreclosure:
When a taxpayer loses a home at a Trustee Sale, the bid amount at the sale is considered their sales price and gain is calculated as in a normal sale (Sales price – Basis). If the property is a home, any capital gain can be excluded under the provisions of the $250K/$500K rules of Section 121. For more information on this calculation download page 4 from Publication 523 on the IRS website. Second thought, download all of Pub 523. It will answer many of your future questions. Short Sales & Forgiveness of Debt: Many ex-homeowners who sell their home under a lender-approved short sale are surprised when they receive a Form 1099 listing the amount forgiven as ordinary income. In my research I am amazed at the different opinions given about this situation by pundits, columnists and other experts. I strongly believe that anyone can have their own opinion but they cannot have their own set of facts. Accountants use a phrase “Safe Harbors.” My opinion is that if I see something on the IRS website it is safer to follow the IRS than some civilian’s opinion.

Is Cancellation of Debt Always Taxable:
What does IRS say? Not always. There are some exceptions. The most common situation 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.

California Law: A debt is considered “nonrecourse” when a loan is made under either one of the following two circumstances:

---When the loan is made to purchase a one-to-four unit property and the borrower intends to occupy at least one of the units, or

---When the seller carries back financing for all or a portion of the purchase price of any real property. (Cal. Code Civ. Proc. §580b.)

Another Info Sources: On September 24th CAR published an outstanding new Q & A, "Taxation of Foreclosures, Deeds in Lieu of Foreclosure and Short Sales". Ask me about getting a copy of this publication.

Finally: According to Inman News, a bill in Congress, HR 3648, The Mortgage Forgiveness Debt Relief Act of 2007 would eliminate a provision of the tax code that allows the IRS to tax debt that's forgiven as ordinary income. To balance the loss of tax dollars IRS would tighten the rules for counting a second home, vacation or rental property as a primary resident for tax exclusion. Let's keep an eye on this bill that recently received unanimous approval from the House Committee on Ways and Means and has the support of NAR and the National Association of Homebuilders.