WHY THE EXPIRATION OF THE MORTGAGE DEBT FORGIVENESS ACT RARELY APPLIES TO ARIZONA SHORT SALES 1

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1 WHY THE EXPIRATION OF THE MORTGAGE DEBT FORGIVENESS ACT RARELY APPLIES TO ARIZONA SHORT SALES 1 After years of extensions to the Mortgage Debt Forgiveness Relief Act, this act will expire at the end of this year. As a result, homeowners were pressured to sell their properties prior to the end of the year and if unsuccessful, told that they may owe a tax next year. But here is the rub; the Mortgage Debt Forgiveness Act does not apply to ninety percent of mortgages in Arizona and these scaremongers have left thousands of Arizona homeowners paralyzed in their underwater home. A. Cancellation of Debt Income Generally, when a debt is forgiven the debtor has to pay taxes on the forgiven debt. The rationale behind this tax is that the taxpayer never paid taxes on the original loan amount because that loan was eventually going to be paid back. As a result the IRS does not consider a loan to be income. But, once a loan is forgiven, because it will not be repaid, the taxpayer has effectively received income. In other words, the taxpayer enjoyed the economic benefit of the forgiven loan and unless that loan is taxed, it would be tax-free money. For instance, if I lend a taxpayer $100 dollars and that taxpayer spends it on a boat, after I forgive the debt, the taxpayer would still own the boat. Unless the government taxes the forgiven $100 dollars, the taxpayer would have bought a boat with tax-free income, creating a windfall for him or her. The Internal Revenue Code eliminates this potential windfall by taxing forgiveness of debt. 1 ANY FEDERAL TAX ADVICE CONTAINED IN THIS DOCUMEN SHOULD NOT BE USED OR REFERRED TO IN THE PROMOTING, MARKETING OR RECOMMENDING OF ANY ENTITY, INVESTMENT PLAN OR ARRANGEMENT, AND SUCH ADVICE IS NOT INTENDED OR WRITTEN TO BE USED, AND CANNOT BE USED, BY A TAXPAYER FOR THE PURPOSE OF AVOIDING PENALTIES UNDER THE INTERNAL REVENUE CODE.

2 Page 2 of 5 December 20, 2013 At times, forgiveness or cancellation of debt income can create harsh results. To alleviate these results, there are provisions in the tax code that mitigate the effect on taxpayers. The Mortgage Debt Relief Act is one of those mitigating provisions. B. The Mortgage Debt Forgiveness Act The Mortgage Debt Forgiveness Act is found in the Internal Revenue Code under section Section 108 is titled Income from Discharge of Indebtedness and only covers cancellation of debt income. What that means is that section 108, and therefore the Mortgage Debt Relief Act, only applies when a taxpayer receives income from the discharge (forgiveness) of indebtedness. So what is the problem? In a short sale, we have a home that is upside down. The short-sale price is less than the outstanding mortgage. Therefore there is a remainder and the bank must have forgiven the remaining portion correct? No that is incorrect. When a loan is non-recourse, and the owner disposes of the property, there is no forgiven debt, therefore there is no cancellation of debt income and therefore the Mortgage Debt Forgiveness Act does not apply! Let me explain. Here in Arizona, under the anti-deficiency statute, most purchase money mortgages on real property are non-recourse obligations. 3 A non-recourse loan means that the lender s only recourse against the homeowner is the property itself. In other words, the lender cannot sue for any deficiency. Under Arizona law, if a mortgage is a purchase-money-mortgage, is secured by a property that is two and half acres or less, and is utilized either as a single one-family-dwelling or a single two-family-dwelling, 2 IRC 108(a)(1)(E). 3 A.R.S

3 Page 3 of 5 December 20, 2013 then the mortgage is non-recourse. If the property and loan qualify, then regardless of any language in the contract, the mortgage is non-recourse. The reason why it is important to differentiate whether a loan is recourse or nonrecourse is not just because it affects whether the lender can sue the homeowner. This distinction also has profound effects on the tax consequences. If, as in almost all instances of purchase money mortgages in this state, a loan is non-recourse, it will not lead to cancellation of debt income 4 and therefore cannot be covered by the Mortgage Debt Forgiveness Act. Instead, what happens is that the amount of non-recourse debt is considered to be the sale price of the property. In other words, the true sale price is ignored and is instead replaced with the amount remaining on the non-recourse loan. 5 That is a difficult concept to grasp. Essentially, the United States Supreme Court ruled that because the lender cannot pursue the borrower for any outstanding deficiency there is no debt to forgive. However, just because a mortgage is non-recourse does not mean the homeowner is off the IRS s hook. Instead the total amount of the debt immediately prior to the foreclosure or short sale will be considered the sale price. The adjusted basis (AB) is the purchase price less any depreciation plus the cost of any major improvements. The taxpayer s gain or loss is the difference between these two numbers. One last point worth considering on non-recourse debt: if the taxpayer has owned and used the property as a principal residence for periods totaling at least two years during the five year period ending on the date of foreclosure/short-sale, then the 4 The Supreme Court Case Commissioner v. Tufts held that non-recourse debt is included in the amount realized and not treated as cancellation of indebtedness. Thus, if there is any difference between basis and amount realized it is treated as a capital gain/loss. See also Treas. Reg (c).

4 Page 4 of 5 December 20, 2013 taxpayer may exclude up to $250,000 ($500,000 for married couples filing jointly) from income. Any excess must be reported as capital gains. Example Taxpayer bought a single-family residence in January 2005 and lived there until December The original purchase price was $220,000, the home is worth $100,000 at short-sale, and the mortgage principal remaining was $200,000. Amount property closed at short-sale = $100,000 Total amount of debt prior to foreclosure = $200,000 Original purchase price = $220,000 The taxpayer ignores the sale price at the short-sale ($100,000) and instead uses the amount of the loan as the sale price for tax purposes ($200,000). Because the taxpayer bought the property for $220,000, the taxpayers gain or loss is $200,000 less $220,000, leaving a long term capital loss of $20,000 The taxpayer would realize long-term capital loss of $20,000. However, because the property is the taxpayer s principal residence, it is not a business loss and the taxpayer cannot use that loss to deduct against income. C. Conclusion Arizona is in the minority of states that have enacted statutes making most residential property purchase-money mortgages non-recourse. As a result of these statutes, the Mortgage Debt Forgiveness Act only applies to a small subset of the population. Unless, you took a cash-out refinance and reinvested the money into your home, the Act probably does not apply to you. That being said, a short-sale may be beneficial to upside-down homeowners. In fact, many Arizonans would benefit from reducing their monthly housing payments and acquiring a property in which they can 5 Id.

5 Page 5 of 5 December 20, 2013 begin building equity. However, the decision to short sale should be made by informed individuals working from sound financial principals. Not scare tactics. Paul Valentine, esq Paul Valentine and Kevin Hardin have been working with Arizona Homeowners to assist them with understanding their rights and obligations related to their mortgage and decisions to resolve their situation. For Tax questions related to Short Sale, Loan Modification, Foreclosure or Deed in Lieu, please call Paul Valentine at For consultation and negotiation of Short Sale, Loan Modification, Deed in Lieu or other foreclosure defense issues, call Kevin Hardin at Paul Valentine obtained his LLM in Tax from New York University Law School and is a federally authorized tax practitioner. He is admitted to the Arizona and Massachusetts Bar. Kevin W. Hardin received his J.D. from Concord School of Law and is a specialized paralegal and Director of the Mortgage Mediation Group at McCarthy Law PLC

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