The housing crisis may have dropped from the headlines in recent years. Unfortunately, however, the crisis remains a reality -a potentially taxable reality- for millions of American homeowners. Debt canceled by banks related to underwater homes (those with mortgage debt that exceeds the home’s fair market value) can be taxable income to the homeowner, even when they lack the funds to pay their mortgage!
During 2017 and 2018, a primary tool allowing homeowners to exclude canceled debt from income, the Qualified Principal Residence Indebtedness Exclusion, was not available. In late 2019, however, The Further Consolidated Appropriations Act, 2020, H.R. 1865, RETROACTIVELY extended the Qualified Principal Residence Exclusion for 2017 through 2020.
The result: Thousands of taxpayers who qualified for this exclusion but were forced to pay tax on canceled debt can amend their returns and get refunds. If you’re an individual who owed taxes on canceled debt related to your home, please contact us to see if you qualify.
The remainder of this article will discuss the challenge faced by those who owe more debt on a home than the home is worth and an overview of remedies to avoid taxes on that debt.
Many Homeowners Remain Underwater: Although housing prices have increased in recent years, it remains highly probable that those who purchased or refinanced (1) a home, (2) a second home, or (3) a rental/investment/business property between 2003 and 2007 still owe more on that property than it is worth. Those in this unfortunate position face one of three choices if they choose to leave the property:
- Abandon the property,
- Lose the property to foreclosure, or
- Sell the property short.
A “short sale” occurs when the mortgage holder allows the property owner to sell at a price less than the balance owed on the mortgage.
Abandonment occurs when the owner leaves the property, and the mortgagee takes possession. Generally, the property gets foreclosed upon later.
Foreclosures (and Deeds in Lieu) occur when the mortgagee takes legal title to a property.
Owners who attempt to short sell their homes have three more choices to consider regarding their mortgage(s):
- Pay off the mortgage balance,
- Refinance the balance with another loan, or
- Ask the lender to agree to cancel all or a portion of the remaining debt.
For many debtors, particularly those having a difficult time making their current mortgage payments, paying off the loan balance or refinancing the balance with another debt will prove financially unrealistic. As a result, many owners ask the lender to cancel the remaining debt.
Be Aware: If the lender cancels the debt – whether the result of a short sale, abandonment or foreclosure - the property owner may owe income tax on the canceled debt.
Taxable Consequences: When a property is sold short, abandoned, or foreclosed upon, and debt gets canceled, two potentially taxable events occur.
- A sale has occurred. A property sold short is generally sold in a standard sales transaction although the sales price is less than the amount owed on the mortgage. When a property is abandoned or foreclosed upon there is no contractual sale but the property is, in effect, sold to its creditors. These “sales” may result in a capital gain or loss that may or may not be taxable depending on the circumstances of the sale (discussed below).
- Short sales and foreclosures may also result in taxable income if any portion of the mortgage is forgiven (unless a specific exception applies – discussed later). This income is called Cancellation of Debt Income.
Calculating Capital Gain/Loss: Calculating taxable gain or loss from a short sale or foreclosure required determination of the property’s sales price.
- For a short sale, this is relatively easy. The sales price is the contract price. Determining the sales price of a foreclosed property, however, is a bit more complex.
- The “sales price” of foreclosed property will depend on whether the property’s mortgage is “recourse” or “nonrecourse.” Recourse loans are loans the borrower remains personally liable for after foreclosure. Nearly all mortgages in thirty-eight states are recourse mortgages. For recourse loans, the “sales price” is the lesser of the loan amount or the fair market value of the property.
Alaska, Arizona, California, Connecticut, Idaho, Minnesota, North Carolina, North Dakota, Oregon, Texas, Utah, and Washington are nonrecourse states. The sales price for properties having nonrecourse includes the canceled debt. There is no canceled debt income but, there could be capital gain income.
To Calculate Capital Gain or Loss: Once “sales price” is determined, the capital gain or loss is calculated by subtracting the owner’s investment, called“basis,” from the sales price. Generally, the owner’s basis represents the owner’s investment in the property. Basis includes (but is not limited to) original purchase price plus capital improvements (such as additions and extensive remodeling). If the difference between the sales price and basis is positive, there is capital gain; if negative, a capital loss.
It may be helpful to keep the following points in mind regarding this gain or loss:
- If there is a capital gain and the owner lived in the property as their primary residence for two of the past five years, the homeowner may be able to exclude all or a portion of the gain from income.
- A capital loss on business or investment property may be deductible.
- Losses on personal-use property – such as a primary residence are not tax-deductible.
Cancellation of Debt Income (CODI): Cancellation of debt income can occur when the amount of recourse debt exceeds the property’s fair market value (or sales price if the property is sold) and the lender forgives the remaining debt. Note: This canceled debt will constitute taxable income unless one or more applies. These exclusions include (but are not limited to):
- Debts discharged in bankruptcy,
- Insolvency immediately before the debt gets forgiven,
- Qualified Farm Debt,
- Qualified Real Property Business Debt, and
- Qualified Principal Residence Indebtedness.
The Bankruptcy exclusion is fairly straight forward but the debt must be discharged in the bankruptcy – before it gets canceled. Proving insolvency, however, requires additional calculations to determine whether the debtor had a negative net worth just prior to the debt cancellation. The Qualified Farm Debt Exclusion requires the property owner to have earned the majority of their income from farming for the previous three years and the debt to be directly related to the business of farming.
The Qualified Real Business Property and Qualified Principle Residence Indebtedness Exclusion apply only to “qualified acquisition debt:” (including refinanced acquisition debt). Acquisition debt is debt used to acquire, construct or substantially improve the property. Any debt forgiven that is not qualified acquisition debt will be taxable unless another exemption applies.
Warning and Take Away–The taxation and canceled debt exclusions related to the sale or loss of an under-water property are highly complex and also often require what is called “Reduction of Tax Attributes.” This or any article can only scratch the surface. If you should find yourself facing the sale or loss of an underwater-property, please seek tax advice before moving forward. As always, this article is for informational purposes only and does not constitute tax advice. If we can be of any assistance with this or any tax or business issue, please feel to contact our office.