DEALING WITH THE BANKRUPT PROPERTY OWNER BY HARRY CHARLES AUGUST 22, 2008 & AUGUST 28, 2008
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1 DEALING WITH THE BANKRUPT PROPERTY OWNER BY HARRY CHARLES AUGUST 22, 2008 & AUGUST 28, 2008 FORECLOSURE: ISSUES, TRENDS AND PERSPECTIVES IN COMMERCIAL LAW MOBAR CLE 1. What is foreclosure for tax purposes? A foreclosure is treated as a sale for tax purposes, resulting in gain or loss. See IRS Rev. Rul , C.B The other problem is that while gain on sale of a personal residence can be excluded, the taxpayer could realize cancellation of indebtedness income. Under Internal Revenue Code (IRC) Sec. 61(a)(3), gain from a property sale is gross income. Cancellation of indebtedness income is also taxed as ordinary income under IRC 61(a)(12). 2. How is gain or loss determined? Look at the difference between the mortgage-holder s basis in the property and the sales amount. Use the following steps to determine the income from foreclosure (Reference: Questions and Answers on Home Foreclosure and Debt Cancellation, Feb. 4, 2008, at at July 28, 2008) Step 1: Figure Cancellation of Indebtedness Income 1-Enter the total amount of debt at the time of foreclosure 2-Enter the fair market value of the property from IRS Form C, box 7 3-Subtract line 2 from line 1. If less than 0, enter 0. E--1 1
2 The difference, above, should equal the amount shown in box 2 of Form 1099-C. This would be a taxable gain unless the taxpayer meets one of the exceptions in step 2, below. The income would be entered on line 21 of IRS Form Step 2: Figure gain from Foreclosure 4-Enter the fair market value of the foreclosed property. If the property loan was non-recourse, then enter the amount of the debt just prior to foreclosure. 5-Enter the adjusted basis of the property, which is generally the purchase price plus improvements that added to the value, such as an addition. 6-Subtract line 5 from line 4. If less than 0, enter 0. The amount on line 6 is the gain from the foreclosure. Taxpayers who owned and used the home as their principal residence for at least two years during the five year period ending on the date of the foreclosure can exclude up to $250,000 (or $500,000 for married couples filing a joint return), from income. If the taxpayer does not qualify for the exclusion or the gain exceeds $250,000 or $500,000, respectively, then the taxpayer reports it as a capital gain on Schedule D, Form 1040 (Capital Gains and Losses). What if the taxpayer lost money on the foreclosure? Is the capital loss deductible? NO Let s work an example. Assume that the taxpayer bought a home in July 2006 and it was foreclosed on in August The purchase price was $180,000 and it was worth $210,000 at the time of foreclosure. The mortgage debt cancelled at the foreclosure was $230,000. At the time of the foreclosure, the debtor was insolvent. He had assets of $230,000 and debts, including his mortgage, car loan, credit cards and payday loans, of $280,000. Use the steps above to calculate the income from the foreclosure: E--2 2
3 1-Enter the total amount of the mortgage debt just prior to the foreclosure $230,000 2-Enter the fair market value of the property reported on IRS Form 1099-C, box 7 $210,000 3-Subtract line 2 from line1 $20,000 This should equal the amount in box 2, Form 1099-C. This is cancellation of indebtedness income and would be entered on line 21, Other Income, of Form NOTE: the Mortgage Forgiveness Debt Relief Act of 2007 changed the recognition of this income, as described below. Now figure the gain from foreclosure 4-Enter the fair market value of the foreclosed property. For nonrecourse loans, show the amount of debt just prior to foreclosure $210,000 5-Enter the adjusted basis in the property $ Subtract line 5 from line 4. If less than 0, enter 0. $30,000 This amount on line 6 is the foreclosure gain on the sale of the home. If the taxpayer had owned and used the home as his personal residence for at least two years during the five years ending on the date of foreclosure, then the taxpayer could exclude up to $250,000 (or $500,000 for married filing joint). If the taxpayer did not qualify for the exclusion, then the taxable amount would be reported as a capital gain on Schedule D, Capital Gains and Losses, Form In this case, the taxpayer would exclude the gain on the sale and exclude the cancellation of indebtedness income under Internal Revenue Code Sec. 108 because they are insolvent (liabilities exceed assets). Under IRC Sec. 108, cancellation of indebtedness income (CODI) E--3 3
4 was excluded if the taxpayer realized the income while in bankruptcy or insolvent. As shown, above, insolvent means that the taxpayer s debts exceed the fair market value of their assets. 3. What s the benefit to a taxpayer transmitting the title to the mortgage company in lieu of foreclosure? As discussed in Mortgage Foregiveness Debt Relief Act of 2007 Reduces Negative Tax Consequences from Foreclosures, by Tom English and Bill Lathen, The CPA Journal, April 2008, the benefit to returning the property to the mortgage holder prior to foreclosure is to reduce unpaid mortgage interest and penalties. This would reduce CODI when the debt on the property exceeds the sale price. 4. What did H.R.3648 and S.1394, the Mortgage Foregiveness Debt Relief Act of 2007, do? It created new IRC section 108(a)(1)(E), which eliminates from gross income up to $2 million of cancellation of indebtedness income resulting from foreclosure of a qualified principal residence that occurs between January 1, 2007 and December 31, Let s break this down Qualified principal residence indebtedness means any debt used to buy, construct, or substantially improve the taxpayer s principal residence if the debt secures the residence. Refinancing debt is also allowed if the refinanced debt didn t add more to the preexisting debt. Thus, extra debt taken out on the house to buy a boat, pay for college, or take a vacation would not be allowed. The basis of the taxpayer s house is reduced by the amount of cancellation of indebtedness income not recognized. This will boost the gain on the foreclosure sale or reduce the loss. However, recall that $250,000 (or $500,000 for joint filers) of gain is not picked up and losses aren t recognized. Thus, this should have no effect on the taxpayer. English & Lathen, id., at 7. As discussed above, if the home equity debt is not used to buy, construct, or substantially improve the principal residence, then E--4 4
5 the cancellation of indebtedness income IS picked up, subject to the other IRC Sec. 108 exclusions (insolvency and bankruptcy). NOTE that only the principal residence is included here vacation homes, rental real estate and investment property are not included. Look at the definition of personal residence in the IRC Sec. 121 regulations. 5. What can I do with a taxpayer who took out a second mortgage to pay medical bills? Are you telling me that they re not covered by the new law? The answer is that they are not covered. You have to look at IRC Sec. 108 insolvency rules. 6. Can a taxpayer challenge the cancellation of income reported on IRS Form 1099-C? English & Lathen, at 8, suggest that the Taxpayer check the lender s later sale of the foreclosed property and any resales of the property. The IRS position is that the taxpayer must first challenge the lender to correct the Form C. English & Lathen also propose that the taxpayer pay for an appraisal of the property prior to foreclosure but I question whether a taxpayer could afford this. If the taxpayer is unsuccessful in attempting to get a corrected Form 1099-C, then it can be challenged by a disclosure statement attached to the taxpayer s IRS Form 1040, documenting why the taxpayer believes that the Form 1099-C is wrong and what steps the taxpayer took to remedy it. English & Lathen also suggest that taxpayers keep documentation to show that they substantially improved the principal residence, in the event that the IRS audits them. 7. My client owes taxes to the IRS and State of Missouri. Can they be discharged in bankruptcy? Yes, taxes are not considered consumer debt for bankruptcy purposes so they can be discharged, as before. There are some new wrinkles to the law, however. See the attached opinion letter. 8. What about offers in compromise with the IRS and the State of Missouri? If my client does recognize income from the foreclosure, can I eliminate the tax debt via an offer? I ve heard about pennies on the dollar settlements. The IRS has tightened E--5 5
6 the offer in compromise rules significantly. Now taxpayers must enter into an installment agreement or obtain currently noncollectible status upfront. In addition, they must offer 20% of their offer amount with the offer and pay a filing fee of $150. The IRS expense limits and other IRS policies make offers difficult. For the State of Missouri, the offer program exists in theory, but is not like the IRS process. 9. How do you determine what is the principal residence under IRC Sec. 121? It s based on the facts, per the IRS Regulations. For a taxpayer who owns a building and rents out the units that he isn t living in, he must allocate the gain or loss on foreclosure. E--6 6
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