"THE IRS's

PAY ME LATER PLAN"

That's what IRS Agents call the new tax rules for homeowners who lose their homes to a lender!

FORECLOSURES

SHORT-SALES

DEED-IN-LIEU

RETURN THE DEED

WALK-AWAYS

LOAN MODIFICATIONS

These can bring serious income tax liabilities if you do not know

how the Tax Code works and how to document your case!

THE BASICS:

1. When a debt is written off, charged off, reduced, restructured, forgiven - whatever language is used to describe the fact that you did not pay it off or replace it with other debt of equal amount - there are a minimum of two different calculations for tax purposes.   The first is to determine whether you have cancellation or discharge of debt income and the second is to determine whether you had a resulting gain or loss on the disposition of the property.

2. Plus, if you used your HELOC or Re-Fi money for something besides paying for the property that is in question, the amount not used to purchase or substantially improve the property should be reported as taxable income in the year the lender charges-off the debt. 

3. First, you must calculate the difference between the loan amount and the fair market value of the property.   The fair market value of the property is generally held (see below) to be the short-sale amount or the amount for which the property was sold by the Sheriff, or the amount the Lender's brother-in-law paid for the property.   The difference between the amount of the debt and the fair market value of the property is taxable as ordinary income (not capital gains).

4. Second, you must also record a "sale" of the property using the fair market value as the sale price (the same fair market value used in #3 above) and figure gain or loss based on that value and your income tax basis in the property.

THE EXCEPTIONS:

PERSONAL RESIDENCE:

1. IRS DOES NOT FORGIVE the amount that the Lender writes off on the mortgages on your personal residence.   This new law is what IRS agents call their "Pay me later plan."

2. If the property is your principal residence, the difference between the amount of the debt and the fair market value of your home is used to reduce the income tax basis of your property for the purpose of determining whether you made a gain of loss when you account for the sale - but not below zero.

3. If the result of #2 is that you made a gain (per IRS) on the sale of your home, you will have to report that sale on Schedule D of your income tax return.   If you qualify for the Section 121 exclusion ($250,000 for single tax payers and $500,000 for married filing jointly - and you know there are exceptions here, as well!) you may not have taxes to pay.  If the result is a loss, you get no deduction because it is your personal residence.

INSOLVENCY EXCLUSION:

1. If the IRS considers you to be insolvent, based on your actual debt and the fair market value of your assets (including IRAs, 401Ks, Annuities, Life Insurance Cash Value - and other assets that are "excluded" for Bankruptcy) the amount of debt that is charged off by the lender - up to the amount by which you were insolvent prior to the charge off - can be used to reduce your income tax basis in the subject property and may possibly impact other property.

2. If the amount by which you were insolvent does not exceed the difference between the debt amount and the fair market value of the property, you have taxable income.

3. You could have taxable income in the amount that debt charged off was not spent on the subject property, plus in the amount that the remaining debt exceeded the fair market value of the property, and have a gain on the sale of the property - obviously depending on the amounts concerned.

EXCLUSION FOR DISCHARGE OF

REAL PROPERTY BUSINESS INDEBTEDNESS:

1. Any taxpayer (except a C Corp) may elect to exclude from gross income the amount by which the debt written off or cancelled exceeds the fair market value of the property.   The amount excluded is treated as a reduction in the tax basis of the real property, so it will increase the gain (or decrease the loss) when the sale is calculated - which must be done in the same tax return in most cases.

BANKRUPTCY EXCLUSION:

1. No amount is included in a taxpayer's gross income by reason of a discharge of indebtedness (in whole or in part) in a bankruptcy proceeding, BUT ONLY IF IT IS A TITLE 11 CASE under the jurisdiction of the court and the discharge is granted by the court.

2. The amount of debt discharged is used to reduce certain tax attributes of the taxpayer and then to reduce the tax basis of depreciable assets or real property held in inventory.

3. Tax attributes reduced include net operating losses and carryovers, capital losses and carryovers, the tax basis of both depreciable and non-depreciable assets and passive activity losses.

"WIGGLE ROOM":

YOURS (FAIR MARKET VALUE)

Fair Market Value is one of the most important numbers in the tax treatment of foreclosures, short-sales, etc.   Yet, FMV is also one of the most subjective numbers.   The IRS will want you to use the amount of the short-sale or the Sheriff sale amount as the FMV, but that is not necessarily the correct number.   There may be other factors - such as the lender's brother-in-law being the buyer, etc. - which could impact the the value.

This means that each taxpayer should carefully evaluate the transactions and have all the facts available and documents to the extent possible when making their calculations of gain or loss or taxable amounts of cancelled debt.

THEIRS (WHEN TO REPORT THE TRANSACTION)

IRS Publication 544 suggests that the correct time to report the gain or loss and taxable income amounts from one of these transactions is when the lender agrees to the transaction and title to the property changes hands.   However, in Coburn v. Commissioner, T.C. Memo, 2005-283, the Tax Court takes the position that "there must be an affirmative showing that the taxpayer is in fact discharged from the indebtedness" before the transaction is reported.

Discharge may not happen until 5 or more years after the note or mortgage goes into default.   This could mean that your tax returns could stay open to examination for 5 years or more, or could mean that IRS will want you to wait until you have had 5 years to recover before they want you to report - and that could cost you money.

Click here for a Brochure with more information