The economic downturn has impacted real estate and business markets in proportions that no one was prepared for. In particular, real estate foreclosures are at an all-time high, and everyone has been affected, from individuals to businesses.
“If a borrower defaults on the mortgage obligation, and the value of the property is less than the debt, the lender may sue the borrower and guarantors for the deficiency,” says Desiree M. Cuason, Esq., an associate with the corporate and tax group at Katz Barron Squitero Faust. “Or, under a variety of settlement scenarios, including short sales and short payoffs, the lender can forgive some or all of the deficiency.”
Smart Business spoke with Cuason about the tax consequences of these scenarios.
What is the Mortgage Forgiveness Debt Relief Act of 2007?
The Act provides that individual taxpayers can exclude from income ‘qualified principal residence’ indebtedness if the balance of the loan is less than $2 million ($1 million for a married person filing a separate return). This includes transactions where debt is reduced through short sales or mortgage forgiveness in connection with a foreclosure. ‘Qualified principal residence’ indebtedness is a mortgage taken out to purchase, build or substantially improve a principal residence. It must be secured by the principal residence.
What debts are excluded from the Act?
The Act only applies to discharges of debt made after 2006 but before 2010. Some exclusions include debt forgiven on second homes or rental properties, debt forgiven on business properties, and debt forgiven on credit cards or car loans.
Can a borrower still be subject to taxes even if the loan qualifies under the Act?
A borrower can be subject to income tax if the debt is more than the cost of the principal residence plus improvements. In addition, borrowers can still be subject to capital gains tax despite the fact that they might qualify under the Act. For example, assume that a single man purchased a qualified principal residence four years ago for $1 million. Since then, he refinanced the property and now owes the bank $1.5 million. The property was foreclosed and sold for $900,000, and the balance of the debt was forgiven. The borrower will be taxed as if the property was sold for $1.5 million. First, his basis will be reduced by the $600,000 of cancelled debt (this amount is not taxable under the Act). Therefore, the basis on the property is now $400,000 ($1 million purchase price less the $600,000 of canceled debt). The borrower will have capital gain of $500,000 ($900,000 proceeds from the foreclosure sale less $400,000 adjusted basis), of which $250,000 will be excluded under an IRS exemption for the sale of a residence (this exclusion would be $500,000 if the borrower was married). The remaining $250,000 is a reportable and taxable capital gain.
What if the lender does not foreclose, but lowers the principal balance on the loan?
If, instead of foreclosing on a property, the lender reduces the balance of the debt to the current value of the property, and the borrower retains the property, the exclusion still applies provided that the eligibility requirements under the Act are satisfied.
What happens when a lender forecloses on the property of an LLC or Limited Partnership?
When a lender forecloses on a property owned by an LLC or Limited Partnership and the debt is secured only by the property, and the members have no personal liability on the debt, there will be no cancellation of indebtedness income. The property is treated as sold for the amount of the debt. However, if the loan is a recourse to all or some of the members, then there will be cancellation of indebtedness income prorata to those members, to the extent that the debt exceeds the fair market value.
What are the tax consequences of a foreclosure or short sale that is not under the Act?
In a foreclosure or short sale of property that does not qualify under the Act, if the mortgage loan exceeds the value of the property, the borrower may have to report a cancellation of indebtedness income, which is usually taxed at ordinary income rates. Losses from sale or foreclosure of personal property are not deductible. Also, if the property is an investment property and depreciation has been taken, the borrower could potentially be required to report depreciation recapture.
What are some exemptions from recognizing cancellation of indebtedness income?
Some exemptions include debt discharged as part of bankruptcy proceedings, if the borrower can prove that it was insolvent at the time debt was discharged, or if the debt that was discharged was ‘qualified real property business indebtedness.’ It is important to note that this will only reduce the basis of the borrower’s depreciable real property, which essentially only postpones tax on the cancelled debt as opposed to entirely forgiving it.
Bottom line, what do taxpayers need to know about the Act?
Affected taxpayers should be aware that, although the Act protects those homeowners whose mortgage debt was incurred exclusively to purchase or substantially improve their primary residence from tax consequences, the Act does not protect from the tax consequences that may result from the forgiveness of debt that is unrelated to the purchase or improvement of the borrower’s primary residence.