Carrie Teegardin, writing for the Atlanta Journal Constitution on 10/15/2007 in an article entitled "Foreclosures Hit Record High In Metro Atlanta", reveals that almost 7,000 properties in the metro area -- a record high -- are up for foreclosure in November, 2007.
Foreclosures in Atlanta are up 11 percent through October, 2007 compared to year-to-date figures from 2006. While many of the unfortunate delinquent debtors find some measure of relief in bankruptcy or reworking their loan terms where pliant lenders are trying to keep their own investors safe, there is another danger waiting for the unwary after the fact: the tax code's treatment of "income" resulting from cancellation of mortgage indebtedness.
Very simply, tax law views foreclosure as a sale. When homeowners sell their houses, they incur losses or realize gains, depending on how much they paid for their houses and how much they are able to fetch in a sale. Those gains are taxable, but those losses are not deductible on personal homes.
For example, John and Mary Homeowner purchase their family home for $300,000.00, pay $15,000.00 down, and borrow the $285,000.00 balance of the purchase price. The Homeowners' mortgage was an "interest-only" mortgage, with no reduction in the principal balance as payments are made. Three years later, both of them are steamrolled by downsizing or market slowdowns in their professions. Refinancing is not an option since their home appraises only for $250,000.00 in the housing slump and a glut of newly built but unsold homes. Furthermore, their personal income simply will not stretch far enough to swing the mortgage payments. They default on their mortgage loan and foreclosure ensues. At the foreclosure sale, the Homeowners' residence sells to the highest bidder for $215,000.00. The Homeowners' $15,000.00 in equity vanishes into thin air. The lender does not pursue the Homeowners personally for the $70,000.00 balance of their indebtedness, knowing that their assets are insufficient to pursue recourse. So, the lender "eats" the $70,000.00 and writes-off the balance as an uncollectable debt.
Under the tax code, the Homeowners have $70,000 in cancellation of debt income in the year of the foreclosure sale. The lender sends the Homeowners a Form 1099-C reflecting this imputed income. Previously unable to pay for the roof over their heads, and having lost their down-payment money to the fates, the Homeowners are behind the proverbial "8-ball" with an additional, present tax liability that likely exceeds $17,000.00.
There are some escape hatches from the full force of the tax hit the Homeowners will suffer, but they do not eliminate the pain altogether. First, to the extent the Homeowners are insolvent (i.e., their liabilities exceed their assets), if they seek bankruptcy protection, they may may reduce the "cancellation of debt" income imputation. Here, if the Homeowners' debts -- including their mortgage debt -- are, for instance, $75,000.00 more than the aggregate value of all of their assets, then they are insolvent to that extent. They do not have to pay taxes on the "income" from cancellation of the debt.
The insolvency sword cuts both ways, however,. If the Homeowners have other depreciable property or certain other categories of losses (net operating losses of a business, capital losses, passive activity losses, or carryovers of any of these, and other specific loss types) they lose their depreciation deduction or the benefit of those losses to the extent of their insolvency. So, if the Homeowners have a net operating loss in their business this year, they will not be able to use that to offset their income from that activity to the extent of $75,000.00. The short-hand, layman's term result is that the government still gets its money from you for the unpaid tax on cancellation of debt income, but in a supposedly "kinder, gentler" manner.
There are other traps and escapes for different type of homeowners. While considering the consequences of a mortgage loan, borrowers should make it their business to know what the potential tax consequences are or could become if their financial outlook is not solidly predictable.
In a future article, I will share with you some ways that homeowners can minimize the brunt of the rules on taxability of "cancellation of debt" income in foreclosures.