Current subprime mortgage lending woes, combined with lower home prices in many markets, can have negative implications for taxpayers who are forced to sell their personal residence or if their lenders foreclose.
Here's what you need to understand about taxes before making any moves in this unfavorable environment.
Tax Results from a "Short Sale"
Real estate pros often call a sale where the mortgage debt exceeds the net sale price (after subtracting commissions and other selling costs) a "short sale." With declining home prices and anxious lenders, short sales are a real possibility for those who must sell in this market. The easiest way to explain the tax results of a short sale is with some examples.
Example 1: Let's say you paid $190,000 for your personal residence, which you could currently sell for a net of $250,000. However, the first and second mortgages against the property total $280,000. If you sell, you'll have a tax gain of $60,000. Why? Because the net sale price exceeds the property's tax basis by that amount ($250,000 sale price minus $190,000 basis equals $60,000 gain).
Will the IRS cut you any slack since you're $30,000 in the red on the deal ($280,000 of debt compared to $250,000 sale price)? Unfortunately, the answer is no. The sad truth is you can have a tax gain without actually having any cash to show for it. Reason: Your mortgage debt doesn't affect your gain or loss calculation.
The good news is you'll probably be able to exclude the $60,000 gain for federal income tax purposes ... thanks to the personal residence home sale gain exclusion break. (Source: Internal Revenue Code Section 121.)
An unmarried person can exclude (pay no federal income tax on) a gain of up to $250,000 from the sale of a principal residence while married joint filers can exclude up to $500,000. Assuming you qualify for the exclusion, the $60,000 short sale gain won't trigger any federal income tax bill for you. Depending on your state of residence, there may be a state income tax bill as well.
Of course, it's also possible to have a short sale for a price that is less than what you paid for the property.
Example 2: This time, assume you paid $310,000 for your home, which you could now sell for a net of only $250,000. The first and second mortgages against the property total $280,000. You'll have a $60,000 loss if you sell ($250,000 sale price minus $310,000 basis equals $60,000 loss).
Does the IRS allow you to write off the loss? Sorry, but no. You can only claim a tax loss on investment property or property used in a business. A loss on a personal residence is considered a nondeductible expense. In most states, the same principle applies for state income tax purposes too.
The next question is: What happens with the $30,000 that's still owed to the mortgage lender in both of the preceding examples ($280,000 of debt versus $250,000 net sale price)? Usually, the lender won't give you any relief. You'll have to figure out a way to pay off the $30,000, and you won't get any tax deductions for doing so.
However, if the lender decides to forgive some or all of the unpaid $30,000, the forgiven amount constitutes so-called cancellation of debt (COD) income for federal income tax purposes. Please keep reading if this is your situation.
Tax Results If Lender Forgives Some Debt
The general rule says that COD income is a taxable item. For the year COD occurs, the lender should report the COD income amount to you (and to the IRS) on Form 1099-C, Cancellation of Debt. As stated earlier, you generally must include the COD amount as income on that year's Form 1040. However, there are various exceptions to the general rule that COD income is taxable. Here are the exceptions most likely to apply to personal residence mortgages in today's troubled environment, under Internal Revenue Code Section 108:
Bankruptcy: If the borrower is in bankruptcy proceedings when the COD occurs, it's entirely exempt from any federal income tax.
Insolvency: If the borrower is insolvent (meaning with debts in excess of assets), the COD income is entirely exempt from any federal income tax as long as the borrower is still insolvent after the COD occurs. On the other hand, if you become solvent due to the COD transaction, you must report income equal to the now-positive difference between your assets and your liabilities (i.e., the amount by which you are now solvent). Any remaining COD income after this step is federal income tax-free.
Deductible Interest: To the extent COD income consists of unpaid mortgage interest that was added to your loan principal and then forgiven, that amount of COD income is federal income tax-free because you could have deducted the forgiven amount if you had paid it.
Seller-Financed Debt: If your COD income is from forgiven seller-financed debt (in other words, mortgage debt that you owed to the previous owner of the property), the COD income is federal income tax-free. Here again, however, you must then subtract the tax-free amount from the basis of your home. If you later sell the property for a gain, the gain will be that much bigger. As explained earlier, however, you probably can exclude the gain under the home sale gain exclusion rules.
Tax Results If a Lender Forecloses
Until now, this article has only dealt with scenarios where you sell your principal residence to a third party. But what happens if the mortgage lender forecloses on your home?
Say your property is foreclosed or transferred to the lender in a deed in lieu of a foreclosure transaction (which amounts to the same thing for tax purposes). When the mortgage debt exceeds the property's fair market value (FMV), the tax rules treat the foreclosure as a sale for the FMV figure. So the foreclosure will trigger a taxable gain if your home's FMV exceeds its basis (typically, your cost plus the price of any improvements to the property). However, you can probably exclude the gain under the rules mentioned earlier.
If the property's tax basis is less than its FMV, the foreclosure generally will trigger a nondeductible loss.
If the lender then forgives all or part of the difference between the higher amount of the mortgage debt and the lower FMV of your home, the forgiven amount is COD income. That income is taxable, unless one of the exceptions explained earlier causes it to be federal income tax-free.
Example 3: You borrowed against the value of your principal residence when local real estate prices were rising. Then the market tanked, and the home was foreclosed. The home's FMV was $250,000 when the foreclosure took place. The property's tax basis was $210,000. You had a $180,000 first mortgage against the property and a $100,000 second (total debt of $280,000).
Assume the full $180,000 first mortgage and $70,000 of the second mortgage get paid off when the lender sells the property. You scrape up $10,000 to pay off part of the remaining $30,000 second mortgage balance. The lender forgives the last $20,000. The federal income tax results are as follows:
1. The foreclosure triggers a $40,000 gain ($250,000 FMV minus $210,000 tax basis equals $40,000). The gain can be excluded under the home sale gain exclusion break, assuming you qualify.
2. The $20,000 forgiven by the second mortgage lender is COD income. It's taxable unless one of the exceptions explained earlier applies.
Congress and the White House are discussing changes to the Tax Code to provide relief, but it is unclear at this time what the outcome will be. (Ed. Note: Some financial industry experts are concerned that other, non-tax provisions in current proposals from Congress and the White House could amount to a taxpayer-financed bailout.)
The key point to understand is that a forced home sale or foreclosure potentially can result in a taxable gain and/or taxable COD income. With luck, however, any gain will be tax-free under the home sale gain exclusion break. Some or all of any COD income may be tax-free too. I hope so, because owing the tax collector in this situation would just add insult to injury.
On the other hand, if you can hang in there until the market improves, you might be able to sell your home for a healthy profit and pay off the lender while owing nothing to the IRS. That would be a much better ending.