Debt Forgiveness in Short Sales

Practice Alert Many homeowners have had to dispose of their homes in short sales (where the sales proceeds are insufficient to pay off the mortgage and the lender cancels the balance) to attempt to get out from under unmanageable debt. AlthoughCode Sec. 108(a)(1)(E) provides relief to many taxpayers from the tax rule that would generally include cancelled mortgage debt in income, taxpayers and their advisors need to be aware of the relief provision's limits.

RIA observation: There is, of course, no loss deduction allowed on a short sale of a personal residence. So a taxpayer who receives less than what he paid for his home cannot use that loss to offset other income. For personal-use property, such as a taxpayer's personal residence, an individual's deduction is limited underCode Sec. 165 to losses arising from fire, storm, shipwreck, or other casualty, or from theft.

Background. In general, a taxpayer realizes income when debt is forgiven. (Code Sec. 61(a)(12)) That's because the discharge of a debt provides the debtor with an economic benefit equivalent to income. The rationale is that the taxpayer should not get to use and keep the forgiven loan proceeds for himself without any tax consequences. However, there are several exceptions and exclusions that may result in all or part of a taxpayer's income from the cancellation of debt being nontaxable. In particular, the Mortgage Relief Act, effective for debt discharged on or after Jan. 1, 2007 and before Jan. 1, 2013, generally allows taxpayers to exclude up to $2 million of mortgage debt forgiveness on their principal residence.

Specifically, under the exclusion, gross income doesn't include any discharge of qualified principal residence debt. (Code Sec. 108(a)(1)(E)) Qualified principal residence debt is acquisition debt under Code Sec. 163(h)(3)(B) with respect to the taxpayers's principal residence, but with a $2 million limit ($1 million for married individuals filing separately). (Code Sec. 108(h)(2)) This exclusion applies where a taxpayer restructures the acquisition debt on a principal residence, loses a principal residence in a foreclosure, or sells a principal residence in a short sale. The exclusion is claimed by filling out Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment), and attaching it to the taxpayers' applicable income tax return. The basis of the taxpayers' principal residence is reduced by the excluded amount, but not below zero.

Illustration 1: Tom owns a principal residence that is subject to an $850,000 mortgage for which he is personally liable. The residence has declined in value to between $700,000 and $750,000. Tom has lost his job and can't find another. The lender has agreed to allow a short sale of the property for $735,000 and to cancel the remaining $115,000 of the $850,000 debt. Tom realizes $115,000 of debt discharge income, which is excludible to the extent that the debt was qualified principal residence debt. (IRS Pub No. 4681, (2009), p. 8)

RIA caution: The mortgage debt forgiveness provision is not an all-encompassing relief provision. It is one of the statutory exceptions to the general rule that debt cancellation results in income, and the relief that it provides only extends as far as the terms of the statute.

Accordingly, in applying this provision, taxpayers and their tax advisors must keep the following in mind: - The mortgage debt forgiveness exclusion applies to cancelled debt, not gain. In some short sales, the taxpayer may have gain from the sale of the property instead of, or in addition to, income from discharge of debt. To the extent that the income is treated as gain, it isn't eligible for the mortgage debt forgiveness exclusion (or for the bankruptcy or insolvency exclusions). For example, when a recourse debt is discharged or reduced on the debtor's transfer of property, the transfer is treated as a sale or exchange of the property to the extent of the transferred property's fair market value (FMV). (Reg. § 1.1001-2(a)(2)) Any gain on this deemed sale or exchange—i.e., any excess of the property's FMV over its adjusted basis—is treated as taxable gain, not as discharge of debt income. The amount of discharged debt in excess of the property's FMV is treated as discharge of debt income. However, all or part of the gain may be excludible from gross income under the Code Sec. 121 home-sale rules, see below.

Illustration 2: In a short sale, Jeff's basis in the home was $170,000, the home's FMV was $200,000, and the outstanding amount of mortgage debt on the home was $220,000. The home is sold for its FMV and the lender cancels the $20,000 balance of the loan. Jeff realizes $30,000 of gain from the sale ($200,000 (home's FMV) − $170,000 (basis) = $30,000). Jeff also realizes $20,000 of discharge of debt income ($220,000 (total outstanding debt) − $200,000 (home's FMV)). (“Questions and Answers On Home Foreclosure and Debt Cancellation,” Fact Sheet HFDC)

RIA observation: Even if the mortgage debt forgiveness exclusion doesn't apply, gain on a home sale may be partially or completely protected by the exclusion under Code Sec. 121. A taxpayer may exclude up to $250,000 ($500,000 for certain joint return filers) of gain from the sale or exchange of property owned and used as his principal residence for two of the preceding five years, unless he excluded gain from another sale or exchange during the preceding two years. Even if the two-out-of-five-year ownership and use rule isn't met, a taxpayer is allowed a reduced maximum exclusion if the sale or exchange was because of a change in place of employment, health, or unforeseen circumstances. Under Reg. § 1.121-3, unforeseen circumstances include an involuntary conversion or a job loss.

- There is no exclusion for debt forgiven on a vacation home, second home, business property, or rental property. The relief provision only applies to a “principal residence.” This term has the same meaning as under the homesale exclusion rules of Code Sec. 121. (Code Sec. 108(h)(5)) A principal residence can be a house, houseboat, mobile home, cooperative apartment, condominium, or house trailer. If a taxpayer was using more than one property as a residence, whether or not a particular property is used by the taxpayer as his principal residence depends on all the facts and circumstances. In no event, however, can a taxpayer have more than one principal residence at any one time.

- The mortgage debt forgiveness exclusion may not apply to a home equity loan or second mortgage. The relief provision only applies to “acquisition debt” of a principal residence. This is debt incurred in the acquisition, construction, or substantial improvement of an individual's principal residence that is secured by the residence. Often a taxpayer takes out a home equity loan (i.e., a type of second mortgage) to use his home as a “piggy bank.” He borrows the money to pay off credit card debt, pay his children's tuition, or even take a long-deferred vacation. While this may be a good financial decision, this debt isn't covered by the relief provision.

Illustration 3: Bill bought a main home for $315,000, using a $300,000 mortgage loan that was secured by the home. Bill later took out a $50,000 second mortgage that was used to add a garage. Both the first and second mortgages qualify for the exclusion. If the second mortgage loan proceeds were instead used to pay credit card bills and college tuition, they wouldn't qualify for the exclusion. (IRS Pub No. 4681, (2009), p. 7)

- The mortgage debt forgiveness exclusion may not fully apply to a refinance mortgage. Refinanced qualified principal residence debt is eligible for the exclusion up to the amount of the old mortgage principal just before the refinancing. (IR 2008-17, H Rept No. 110-356 (PL 110-142) p. 5) If the amount of the taxpayer's original mortgage is more than the cost of the principal residence plus the cost of any substantial improvements, only the debt that doesn't exceed the cost of the principal residence plus improvements is qualified principal residence debt. (Instructions to Form 982, (3/2009), p. 4) Illustration 4: Assume that Bill in Illustration (3) refinanced the first and second mortgages into a single loan of $400,000, when the outstanding principal was $325,000. Bill used $75,000 of the loan proceeds to pay credit card bills. Only $325,000 of the $400,000 refinanced debt is qualified principal residence debt that is eligible for the exclusion. (IRS Pub No. 4681, (2009), p. 7)

- The mortgage debt forgiveness exclusion doesn't apply if the discharge of the loan was on account of services performed for the lender or any other factor not directly related to a decline in the residence's value or to the taxpayer's financial condition. (Code Sec. 108(h)(3)) Thus, where the debtor is employed by the lender, and the discharge of debt relates to the employment services performed, the discharge won't qualify for the exclusion.

- The exclusion doesn't apply to a taxpayer in a Title 11 bankruptcy. (Code Sec. 108(h)(3)) An insolvent taxpayer (other than one in a Title 11 bankruptcy) can elect to have the mortgage forgiveness exclusion not apply and can instead rely on the Code Sec. 108(a)(1)(B) exclusion for insolvent taxpayers. (Code Sec. 108(a)(2))

RIA observation: A taxpayer or his advisor should be aware of all the exclusions under Code Sec. 108. No amount is included in a taxpayer's gross income by reason of a discharge of debt if the discharge:
  • occurs in a Title 11 (bankruptcy) case;
  • occurs when the taxpayer is insolvent;
  • is a discharge of qualified farm debt;
  • is a discharge of qualified real property business debt of a taxpayer other than a C corporation; or
  • is a discharge of up to $2 million of mortgage debt on the taxpayer's main home

RIA Research References: For the mortgage debt forgiveness exclusion, see FTC 2d/FIN ¶ J-7417; United States Tax Reporter ¶ 1084.01; TaxDesk ¶ 188,029.

Source: Federal Tax Updates on Checkpoint Newsstand tab 4/21/2011 Posted: 3.2.2012