by Jeff Smoot

Homeowners and real estate investors facing potential foreclosure have many options to consider: seeking a loan modification, negotiating a short sale with the lender, giving the lender a deed in lieu of foreclosure, letting the house go to foreclosure, or filing bankruptcy. When considering these options, tax implications should always be considered, because some of these actions can lead to cancellation of debt income—taxable income that could easily be avoided with tax and legal advice.

In the real estate context, cancellation of debt income such as a reduction of principal or deed in lieu generally arises when you borrow money and the lender later cancels or forgives the debt. When you borrowed the money, the loan was not considered income because you had an obligation to repay it. When you don’t repay it and the lender cancels or forgives the debt, the money you didn’t repay is treated as income. So, if the bank approves a short sale and you sell the house for $50,000 less than you owe on it, that $50,000 may be taxable income. Or if you give the bank a deed in lieu of foreclosure and the bank sells the house at auction for $100,000 less than you owe, that $100,000 may be taxable income. Many people who did a short sale or gave the bank a deed in lieu of foreclosure have been surprised to receive a Form 1099-C. Unable to pay the potentially large tax bill, they consider filing bankruptcy, only to find out that, because a taxable event occurred prior to filing, the cancellation of debt income tax debt will not be discharged in their bankruptcy.

Fortunately, cancellation of debt income is not always taxable. In fact, more often than not, reduction of debt as part of a settlement or compromise does not create taxable income. There are several exceptions, including:

• If the property is your qualified principal residence, the Mortgage Debt Relief Act of 2007 provides an exception. Generally, the Act allows exclusion of income realized as a result of modification of the terms of the mortgage, or foreclosure on your principal residence. However, if it is not your principal residence (e.g., it is a vacation home or rental property), this Act does not apply.

• If you are insolvent when the debt is canceled (i.e., your total debts are more than the value of your total assets), some or all of the canceled debt may not be taxable. A tax attorney or CPA can help you make this determination.

• If the loan is non-recourse (i.e., the lender’s only remedy is to repossess or foreclose and the lender cannot pursue you personally in case of default), any unpaid loan balance is not taxable as cancelation of debt income, but there may be other tax consequences. Again, a tax professional can help you make this determination.

• Debt that is canceled as part of a settlement or compromise of a legitimately contested and doubtful debt is not considered taxable income in most jurisdictions.

• Debts discharged in bankruptcy are not considered taxable income.

Often, borrowers can minimize or eliminate any cancellation of debt liability while in negotiations with the lender for a short sale or deed in lieu of foreclosure by getting the lender to agree that the debt is being canceled as part of a compromise of a legitimately contested and doubtful debt and to treat the loan as a non-recourse loan and seek recovery only from the property. This can avoid potential cancellation of debt income. (But again, there may be other tax implications and you should consult with a tax attorney or CPA before proceeding.) The important thing is to get it in writing, so when the lender “forgets” its agreement and issues you a Form 1099-C, you have documentation to provide to the IRS to show that the 1099 was issued in error.

The timing of a short sale or deed in lieu of foreclosure is critical if you are considering filing bankruptcy in the near future. Again, debts discharged in bankruptcy are not considered taxable income. However, if you do a short sale or give the lender a deed in lieu before you file bankruptcy, that creates a taxable event that may result in cancellation of debt income tax liability that cannot be discharged in bankruptcy unless you wait more than three years to file and otherwise qualify for a discharge of tax liability. If bankruptcy is something you are considering in conjunction with a pending foreclosure, short sale, or deed in lieu transaction, you should consult with a bankruptcy attorney before proceeding.

If you have already entered into a compromise with a lender and completed a short sale or deed in lieu or agreed to a loan modification that reduced the principal amount of your debt, even if one of the above exceptions applies, you may still receive a Form 1099-C. If so, you should consult with an attorney or tax advisor immediately to determine whether the asserted forgiveness of debt income can be challenged. Never assume that forgiveness of debt income is valid. In many cases, it is not.

This article is for informational purposes only, and should not be relied upon as legal advice. No attorney-client relationship is created or intended by publication of this article. If you desire legal advice or representation regarding the issues discussed in this article, please contact Highpoint Law Group PLLC.

Notice: Under IRS regulations, we must inform you that any U.S. tax advice contained in the body of this article was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under federal tax law. By regulation, a taxpayer cannot rely on professional advice to avoid federal tax penalties unless that advice is reflected in a comprehensive tax opinion that conforms to strict requirements.

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