Foreclosures, Repossessions, and Cancelled Debt

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1 CPE/CE 4 Credit Hours Foreclosures, Repossessions, and Cancelled Debt Help Clients Get Back on Their Feet 2014 Tax Year Interactive Self-Study CPE/CE Course

2 Foreclosures, Repossessions, and Cancelled Debt Self-Study CPE/CE Course Overview Program Content: Publication Date: September Expiration Date: Field of Study: Program Level: Recommended Participants: Prerequisites: Advance Preparation: Type of Delivery Method: CPE/CE Credit Hours: Passing Grade: Record Retention: This course provides continuing professional education for tax professionals to enhance knowledge of tax treatment of issues commonly associated with clients who have property foreclosed or repossessed. Subject matter includes tax reporting income from cancellation of debt, exceptions to taxation of income from the cancellation of debt, 1099-series forms, and effect on tax attributes of debt cancellation. The Final Exam must be completed online within one year from your date of purchase or shipment. See the Final Examination Instructions on the next page for information regarding final exam completion. Taxes. Overview. This course provides a general overview of the subject area from a broad perspective. It is appropriate for tax professionals at all organization levels. Tax professionals who prepare individual income tax returns are encouraged to participate in this course. Individuals who have prepared Form 1040 tax returns. No advanced preparation is needed to complete this course. Interactive self-study. 4 Credit Hours. One 50-minute period equals one CPE/CE Credit Hour. Participants who answer a minimum of 70% correct on the final exam will receive a Certificate of Completion. See the Final Examination Instructions on the next page for further information regarding passing requirements and acquiring the Certificate of Completion. As an IRS-approved provider of continuing education, Tax Materials, Inc. will report successful completion of this course to the IRS. According to the IRS, at some point in the future, you will be able to view your completed continuing education credits through your online PTIN account. Complaint Resolution Policy: Please contact our customer service department toll-free at Refund Policy: 30-day money-back guarantee. For information about our refund, complaint, and/or program cancellation policies, visit our website at Tax Materials, Inc. is registered with the National Association of State Boards of Accountancy (NASBA) as a sponsor of continuing professional education on the National Registry of CPE Sponsors. State boards of accountancy have final authority on the acceptance of individual courses for CPE credit. Complaints regarding registered sponsors may be submitted to the National Registry of CPE Sponsors through its website: National Registry of CPE Sponsors ID Number In accordance with the standards set forth in Circular 230, section 10.6, CPE/CE credits have been granted based on a 50-minute hour. IRS Program Number is 7VT8K-T S Tax Materials, Inc. has been approved by the California Tax Education Council to offer the Foreclosures, Repossessions, and Cancelled Debt Self-Study CPE/CE Course 6193-CE-0024, which provides 4 hours of federal credit and 0 hours of state credit towards the annual continuing education requirement imposed by the State of California. A listing of additional requirements to register as a tax preparer may be obtained by contacting CTEC at P.O. Box 2890, Sacramento, CA, , toll-free by phone at , or on the internet at CTEC Course ID Number 6193-CE-0024 Copyright 2014 Tax Materials, Inc. All Rights Reserved TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Overview i

3 Foreclosures, Repossessions, and Cancelled Debt Self-Study CPE/CE Course Completion Instructions Helpful Hint: Attempt to relate your tax preparation experience with the information you are studying. By doing so, you will increase retention and maximize your results. Also, utilize the Notes sections to jot down reminders and information that will be helpful to you in your tax practice. Follow the instructions below: 1) Start each chapter by reading the Learning Objectives. 2) Read the course materials in the chapter. Pay close attention to: a) Key Facts: Information that is particularly pertinent to the Learning Objective. b) Examples: Review the examples to associate the information to real-world application. c) Notes: Many of the main points of the chapter are highlighted. Review the notes and try to relate the content with your experience. 3) Complete the Self-Quiz at the end of the chapter. The questions are broken out by Learning Objective. Review the Learning Objectives before completing each set of questions. Determine your progress by comparing your answers to the correct ones on the pages that follow. 4) After all chapters have been studied, and each Self-Quiz has been taken, complete the Final Exam located at the back of this instruction booklet. Final Examination Instructions Expiration Date Reminder: The Final Exam must be completed online within one year from your date of purchase or shipment. CPE/CE credits are not available more than one year after your date of purchase or shipment. All Final Exams are administered online at It is recommended that you review the Final Exam at the end of the course before taking it online. Final Exams mailed in will not be graded. Follow the instructions below: 1) Go to 2) Click on Login to Education Center, where you will find a location to log in to the Final Exam. 3) Enter your User Name in the self-study CPE/CE login location. The address associated with your account at Tax Materials, Inc. is your User Name. If you do not have an address, or have not provided one, please call our toll-free number at to be assigned a User Name. 4) Enter your Password. The zip code associated with your account is your password. If you are having difficulty logging onto the Final Exam, please call our toll-free number at ) Select the Foreclosures, Repossessions, and Cancelled Debt Exam and click the Take Exam button. 6) You will be taken to the Final Exam. First confirm your First Name and Last Name are correct. This is how your name will appear on your Certificate of Completion should you achieve a score of 70% or higher. Take the Final Exam. Read the questions carefully and answer them to the best of your ability. At the bottom of the exam, click on Submit Answers when finished. You will instantly know if you have passed the test. If you failed, you are able to retake the test. If you passed, the Certificate of Completion will be available for you to print. Complete Evaluation Form Please provide suggestions and feedback regarding this CPE/CE course. The last page contains an Evaluation Form. After completion, please mail to: Tax Materials, Inc Minnetonka Ind. Rd., Ste. 221 Minnetonka, MN Thank you for helping us improve our CPE/CE course offerings! ii Overview TheTaxReview Foreclosures, Repossessions, and Cancelled Debt

4 Learning Objectives / Table of Contents Chapter 1 Cancelled Debt A Differentiate between recourse and nonrecourse debt. 1-B Identify characteristics of Forms 1099-A and 1099-C issued in respect to abandoned property or cancelled debt. 1-C Determine how to properly report income from cancelled debt on the tax return. 2 Cancelled Debt as Income A Identify the tax effects of discounts and loan modifications. 2-B Apply exceptions to cancelled debt as income. 2-C Identify taxpayers who qualify to exclude cancelled debt from income using Form Foreclosures and Repossessions A Explain the tax consequences of the Mortgage Forgiveness Debt Relief Act of 2007 to clients. 3-B Identify the tax effect on the borrower when property that is collateral for a loan is abandoned, foreclosed, or repossessed. 3-C Identify the tax effect on the seller or lender when property that is collateral for a loan is abandoned, foreclosed, or repossessed. 4 Form A Identify required tax attribute reductions resulting from exclusions of debt cancellation income. 4-B Determine the extent to which a taxpayer is insolvent. 4-C Properly report exclusion of debt cancellation income and reduction of tax attributes on Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustments). Final Exam Index Course Evaluation TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Table of Contents iii

5 iv Table of Contents TheTaxReview Foreclosures, Repossessions, and Cancelled Debt

6 1 Cancelled Debt Learning Objectives Successful completion of this course will enable the participant to: 1-A Differentiate between recourse and nonrecourse debt. 1-B Identify characteristics of Forms 1099-A and 1099-C issued in respect to abandoned property or cancelled debt. 1-C Determine how to properly report income from cancelled debt on the tax return. CPE/CE Glossary Terms Abandonment. Abandonment is the intentional and permanent action of a borrower to discard property from use and relinquish ownership, as indicated by objective facts and circumstances. Foreclosure. A lender forecloses on property that secures a loan when the borrower no longer has the right to redeem the property by making payments to the lender. Foreclosure proceedings may be judicial (involving court action) or nonjudicial (no court involved). Nonrecourse debt. A debt that the borrower is not personally liable to repay is a nonrecourse debt. Recourse debt. A debt that the borrower is personally liable to repay is a recourse debt. Repossession. A lender repossesses property that secures a loan when the lender reacquires or takes possession of the property in full or partial satisfaction of the loan. Learning Objective 1-A Differentiate between recourse and nonrecourse debt. Cancellation of Debt Basics A debt includes any indebtedness for which a taxpayer is liable or which attaches to the taxpayer s property. Cancellation of indebtedness can involve auto loans, credit card debt, medical care, professional services, installment purchases of furniture or other personal property, mortgages, and home equity loans. Generally, if a debt for which a taxpayer is personally liable is cancelled or forgiven, the taxpayer must include the cancelled amount in income. There is no income from cancelled debt if the cancellation or forgiveness of debt is a gift or bequest. TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Chapter 1 1

7 NOTES Acquisition debt tends to be nonrecourse debt, since the property being purchased is usually collateral for the loan. Recourse vs. Nonrecourse Debt Debt for which a borrower is personally liable is referred to as recourse debt. All other debt is nonrecourse debt. State law may specify which loans can be recourse loans. Whether a debt is recourse or nonrecourse may vary from state to state, depending on state law. Recourse debt. Refinances, second mortgages, and equity loans tend to create recourse debt. The borrower is personally liable to repay any amount of debt not satisfied by the surrender of the property securing the debt. The lender can repossess the loan collateral, but the borrower remains responsible for any deficiency if the property does not fully repay the loan. Lenders have the right to garnish wages or levy accounts in order to collect what is owed. Nonrecourse debt. Acquisition debt tends to be nonrecourse debt, since the property being purchased is usually collateral for the loan. Nonrecourse debt is satisfied by the surrender of the property securing the loan, regardless of the FMV of the property at the time of the surrender. The borrower is not personally liable for the debt after the surrender of the property. The creditor or lender has no recourse for collecting any part of the debt after the property securing the loan has been surrendered. Example Andrew buys a nice new car, financed by a $25,000 loan from the car dealership. Andrew s loan documents state that if Andrew defaults on the car loan, he is responsible to pay the difference between the FMV of the car and the remaining balance on the car loan. The car loan is recourse debt. Example Tina starts a new business and the business borrows $50,000 to buy equipment from an equipment reseller. The loan documents state that the equipment is collateral for the loan and that surrender of the equipment will satisfy the debt. Tina s equipment loan is nonrecourse debt. Example Denise borrows $150,000 to buy her home. The loan is secured by the home. Denise lives in a state in which home acquisition indebtedness is considered nonrecourse debt. After a few years, Denise s home value has increased enough that she is able obtain a home equity loan for $20,000. In Denise s state, home equity loans are specifically classified as recourse debt. Denise is personally liable to repay the $20, Chapter 1 TheTaxReview Foreclosures, Repossessions, and Cancelled Debt

8 State Laws The following steps can be taken to determine whether a debt is recourse or nonrecourse: Check the state s lending statutes. State laws dictate whether a loan is recourse or nonrecourse. Check the state s laws on deficiency judgments. These laws determine whether a lender has the right to seek recourse. Review all loan documents. The documents may state whether the loan is recourse or nonrecourse. Note that state law overrides what the loan documents may say. Get legal advice, or in the case of a potential foreclosure, consult a HUDapproved foreclosure prevention counselor. The legal expert or counselor can review the loan documents and interpret the language regarding recourse and nonrecourse loans. Recourse mortgage state. States that are not nonrecourse mortgage states are recourse mortgage states. In a recourse state, the lender may be able take collection action against the borrower for loan deficiencies even if the lender acquires the home through foreclosure or repossession. Nonrecourse mortgage state. If state law does not hold a borrower personally liable for more than the home s value at the time the loan is repaid, the state is referred to as a nonrecourse mortgage state. That is, the lender may foreclose on a home in satisfaction of the loan, but may not pursue the borrower for the amount by which the loan exceeds the home s value. Anti-deficiency laws vary from state to state. Some states have determined that only purchase money, or money used in the initial acquisition of the home, qualifies as nonrecourse debt. NOTES State laws dictate whether a loan is recourse or nonrecourse. Lender Reporting A lender may be required to file Form 1099-C, Cancellation of Debt, or Form 1099-A, Acquisition or Abandonment of Secured Property, or both. Each form includes Box 5 with the same wording: Check here if the debtor was personally liable for repayment of the debt. When the box is checked, that means that the debt in question was recourse debt. When the box is not checked, the debt is nonrecourse debt. Note: Forms 1099-C and 1099-A are often incorrect. If box 5 has been checked, care should be taken to determine whether the debt was in fact a recourse debt. If box 5 has been erroneously checked, ask the lender to issue a corrected form. See Learning Objective 1-B, page 4, for more information about Forms 1099-C and 1099-A. TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Chapter 1 3

9 NOTES Potential Tax Consequences Key Fact Even though a lender may not be able to pursue collection of the unpaid balance of a nonrecourse debt, the debt cancellation amount may be considered income by the IRS. If property securing a debt is repossessed, foreclosed on, or abandoned, the taxpayer may need to report the disposition as a sale. The date of the sale depends on whether the debt secured by the property was nonrecourse debt or recourse debt. Nonrecourse debt. If the taxpayer abandons property that secures a debt for which the taxpayer is not personally liable, the abandonment is treated as a sale or exchange that occurs on the date of abandonment. Recourse debt. Generally, if the taxpayer abandons property that secures a debt for which the taxpayer is personally liable, the taxpayer does not have a gain or loss until the later foreclosure is completed. See Chapter 3, Foreclosures and Repossessions, page 39. See Learning Objective 1-C, page 11, for more information about reporting income from cancelled debt. Learning Objective 1-B Identify characteristics of Forms 1099-A and 1099-C issued in respect to abandoned property or cancelled debt. If the creditor is a commercial lender and that obligation is subsequently cancelled, the creditor will issue Form 1099-C, Cancellation of Debt, to report the cancellation to the IRS. Form 1099-A and Form 1099-C A taxpayer may receive either Form 1099-A or Form 1099-C or both in connection with the same debt. Form 1099-A, Acquisition or Abandonment of Secured Property. When someone borrows money from a lender to buy property, the lender may require the loan to be secured by the purchased property. Property includes real estate, personal property, and intangible property. If the borrower transfers an interest in the secured property to the lender (such as in a foreclosure) or abandons the property, the lender reports the acquisition or abandonment to the IRS by filing Form 1099-A, Acquisition or Abandonment of Secured Property. Form 1099-C, Cancellation of Debt. When someone borrows money from a lender, the loan proceeds are not includable in income because the borrower has an obligation to repay the lender later. If the creditor is a commercial lender and that obligation is subsequently cancelled, the creditor will issue Form 1099-C, Cancellation of Debt, to report the cancellation to the IRS. Key Fact Form 1099-A is used to report information about foreclosed, repossessed, or abandoned property and debt associated with the property. Form 1099-C is used to report information about cancelled debt. 4 Chapter 1 TheTaxReview Foreclosures, Repossessions, and Cancelled Debt

10 Comparison of Form 1099-A and Form 1099-C NOTES Form 1099-A, Acquisition or Abandonment of Secured Property What is the purpose of the form? Reports information about property that secures a loan. Alerts the IRS that the lender may issue Form 1099-C at some point in the future. Who must file the form? A taxpayer that lends money in the course of a trade or business, even if the taxpayer is not in the business of lending money. When is the form issued? A lender repossesses or forecloses on property that was security for a loan, or A lender acquires property that the borrower abandoned. What is reported? Names, addresses, and identification numbers of lender and borrower, as well as lender s phone number. Box 1: Date of foreclosure, repossession, or abandonment. Box 2: Balance of debt principle outstanding. Box 4: Fair market value of the foreclosed, repossessed, or abandoned property. Box 5: Whether the borrower was personally liable for the debt. Box 6: Description of foreclosed, repossessed, or abandoned property. Form 1099-C, Cancellation of Debt Reports debt that has not been repaid by the borrower. Notifies the IRS that the borrower has income from debt cancellation. A financial institution, credit union, certain Federal corporations and agencies, or any organization in the trade or business of lending money. A lender cancels or forgives a debt of $600 or more, or An identifiable event occurs for which the IRS requires the debt to be treated as cancelled. Names, addresses, and identification numbers of creditor and debtor, as well as creditor s phone number. Box 1: Date of debt cancellation or identifiable event. Boxes 2 and 3: Amount of debt discharged and any included interest. Box 4: Description of debt. Box 5: Whether the borrower was personally liable for the debt. Box 6: Identifiable event code. Box 7: Fair market value, if foreclosure or abandonment of property has occurred. Identity Theft and Debt Cancellation Form 1099-C should not be issued when fraudulent debt is cancelled due to identity theft. A taxpayer who receives Form 1099-C in this instance should ask the lender to file a corrected form, since the cancelled debt was not actually the taxpayer s liability. Example Laurie s business equipment is collateral for a $35,000 business loan. In 2014, Laurie defaults on the business loan and surrenders the equipment to the lender. The lender will file Form 1099-A to report its acquisition of the equipment. TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Chapter 1 5

11 NOTES Example In 2008, Tom borrowed $200,000 to purchase a home. In 2014, Tom s business fails and he is unable to continue making house payments. Because the loan balance is now $180,000 but the home has lost value and was worth only $150,000, Tom decides to abandon his home and permanently moves out on July 1, His lender will file Form 1099-A to report the abandonment. Example Joel borrowed $1,200 from Missy. He was unable to repay the debt, so Missy agreed to accept $500 in satisfaction of the entire debt. Joel has cancelled debt of $700. Missy is not in the trade or business of lending money, so she is not required to file Form 1099-C. Suppose that instead of settling his debt to Missy for $500, Joel agrees to paint Missy s house in full satisfaction of the debt. Joel has income from services, not cancellation of debt income. Example In 2013, someone used Jamie s identity to obtain credit cards and run up large debts in his name. When the identity theft is discovered in 2014, the credit card company cancelled the debt as far as Jamie is concerned. Jamie does not have debt cancellation and should not receive Form 1099-C. Box 6 on Form 1099-C reports the reason a creditor is filing Form 1099-C. Form 1099-C Identifiable Event Codes Box 6 codes. Box 6 on Form 1099-C reports the reason a creditor is filing Form 1099-C. Use of this box is mandatory for tax years beginning after The identifiable event codes refer to specific events that indicate that a debt has been cancelled and thus trigger the requirement to file Form 1099-C. Code A. Bankruptcy. Code A is used to identify cancelled debt as a result of a Title 11 bankruptcy case. Code B. Other judicial debt relief. Code B is used to identify cancellation of debt as a result of receivership, foreclosure, or similar federal or state court proceedings other than bankruptcy. Code C. Statute of limitations or expiration of deficiency period. Code C is used to identify cancellation of debt when the statute of limitations for collecting the debt expires, or when the statutory period for filing a claim or beginning a deficiency judgment proceeding expires. Note: An identifiable event in the case of expiration of a statute of limitations occurs only if and when the borrower s affirmative defense of the statute of limitations is upheld in a final judgment or decision in a judicial proceeding, and the period for appealing the judgment or decision has expired. Code D. Foreclosure election. Code D is used to identify cancellation of debt when the creditor elects foreclosure remedies that statutorily end or bar the creditor s right to pursue collection of the debt. This event applies to a mortgage lender or holder who is barred from pursuing debt collection after a power of sale in the mortgage or deed of trust is exercised. 6 Chapter 1 TheTaxReview Foreclosures, Repossessions, and Cancelled Debt

12 Code E. Debt relief from probate or similar proceedings. Code E is used to identify cancellation of debt resulting from probate court or similar proceedings. Code F. By agreement. Code F is used to identify cancellation of debt as a result of an agreement between the creditor and the debtor to cancel the debt at less than full consideration. Code G. Decision or policy to discontinue collection. Code G is used to identify cancellation of debt because of a decision or defined policy of the creditor to discontinue collection activity and cancel the debt. A defined policy includes both a written policy and the creditor s established business practices. Code H. Expiration of nonpayment testing period. Code H is used to indicate that the creditor has not received a payment on the debt during a testing period ending on the December 31. The testing period is a 36-month period increased by the number of months the creditor was prevented from engaging in collection activity by a stay in bankruptcy or similar bar under state or local law. This identifiable event applies only for a creditor that is a financial institution, credit union (and certain of their subsidiaries), or one of certain other Federal corporations and executive agencies. Expiration of the nonpayment testing period does not necessarily result from an actual discharge of indebtedness. Code I. Other actual discharge before identifiable event. Code I is used to identify an actual cancellation of debt that occurs before any of the identifiable events described in codes A through H. Key Fact Form 1099-C codes A through G and I identify specific occurrences resulting from actual discharge of indebtedness. These events determine the date of debt cancellation that is listed in box 1 of Form 1099-C. Code H does not necessarily identify an actual discharge of indebtedness. Coordination of Form 1099-A and Form 1099-C. A taxpayer may receive both Form 1099-A and Form 1099-C in connection with the same indebtedness. For example, the lender may foreclose on property that secures a debt, and then later cancel all or part of the outstanding loan. If the lender sells the property or cancels debt after the foreclosure or abandonment, the taxpayer may receive both Forms 1099-A and 1099-C. If the debt cancellation or sale occurs in the same calendar year as foreclosure or abandonment of the property, the taxpayer may receive only Form 1099-C. Completion of boxes 4, 5, and 7 on Form 1099-C satisfies the lender s filing requirement for Form 1099-A. The taxpayer may receive Form 1099-A in the year of the foreclosure or abandonment, but may receive Form 1099-C in a later year when the property has been sold or cancellation of debt has occurred. In this case, boxes 4, 5, and 7 should be left blank on Form 1099-C since the information in those boxes has already been reported on Form 1099-A. If the FMV of the foreclosed or abandoned property exceeds the outstanding loan secured by the property, no debt cancellation occurs. The taxpayer may receive Form 1099-A to report the foreclosure or abandonment, but Form 1099-C should not be issued in connection with the indebtedness. NOTES A taxpayer may receive both Form 1099-A and Form 1099 C in connection with the same indebtedness. TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Chapter 1 7

13 NOTES Form 1099-C issued to more than one person. If two taxpayers are jointly and severally liable for a debt that was cancelled, both taxpayers may receive Form 1099-C showing the entire amount of the cancelled debt. The amount that is reportable on each taxpayer s tax return depends on the following: State law. The amount of loan proceeds each taxpayer received. How much of any interest deduction from the debt has been claimed by each taxpayer. How much of the basis of any co-owned property purchased with the loan proceeds was allocated to each co-owner. Whether the cancelled debt qualifies from any of the exceptions or exclusions discussed in Chapter 2, Cancelled Debt as Income, page 21. Example #1 In 2006, Pam bought her main home for $235,000. She made a $15,000 down payment and took out a mortgage secured by the home for $220,000. Eventually, Pam was unable to make the mortgage payments. On March 1, 2013, when the outstanding balance of the loan was $215,000 and the home was worth $190,000, the lender foreclosed on the home. On January 15, 2014, the lender sold the home for $190,000 and cancelled the remaining mortgage debt. Pam received a 2013 Form 1099-A showing the following information: Box 1: March 1, 2013 (date of foreclosure). Box 2: $215,000 (balance of principle outstanding). Box 4: $190,000 (fair market value of property). Box 5: Checked, if the loan was a recourse loan. Box 6: Property address CORRECTED (if checked) LENDER S name, street address, city or town, province or state, country, ZIP or foreign postal code, and telephone no. Mortgage Lender LENDER S federal identification number BORROWER S name Pam Street address (including apt. no.) BORROWER S identification number City or town, province or state, country, and ZIP or foreign postal code Account number (see instructions) OMB No Form 1099-A 1 Date of lender's acquisition or 2 Balance of principal knowledge of abandonment outstanding 3/1/2013 $ 215, Fair market value of property $ 190,000 5 If checked, the borrower was personally liable for repayment of the debt X 6 Description of property (address of home) Form 1099-A (keep for your records) Acquisition or Abandonment of Secured Property Copy B For Borrower This is important tax information and is being furnished to the Internal Revenue Service. If you are required to file a return, a negligence penalty or other sanction may be imposed on you if taxable income results from this transaction and the IRS determines that it has not been reported. Department of the Treasury - Internal Revenue Service The next year, Pam also received a 2014 Form 1099-C showing the following: Box 1: January 15, 2014 (date of identifiable event). Box 2: $25,000 (amount of debt discharged). Box 3: Blank, because the lender did not include interest in the box 2 amount. Box 4: Blank, because Form 1099-A was previously filed for this debt. Box 5: Blank, because Form 1099-A was previously filed for this debt. Box 6: Code D, since the lender has decided to foreclose on the home rather than pursue collection of the loan Pam defaulted on. Box 7: Blank, because Form 1099-A was previously filed for this debt. continued on next page 8 Chapter 1 TheTaxReview Foreclosures, Repossessions, and Cancelled Debt

14 Example #1 continued NOTES CORRECTED (if checked) CREDITOR'S name, street address, city or town, state or province, country, 1 Date of identifiable event OMB No ZIP or foreign postal code, and telephone no. 1/15/2014 Mortgage Lender 2 Amount of debt discharged Cancellation $ 25, of Debt 3 Interest if included in box 2 $ Form 1099-C CREDITOR'S federal identification number DEBTOR'S identification number 4 Debt description Copy B DEBTOR'S name Pam Street address (including apt. no.) 5 If checked, the debtor was personally liable for For Debtor This is important tax information and is being furnished to the Internal Revenue Service. If you are required to file a return, a negligence repayment of the debt penalty or other sanction may be City or town, state or province, country, and ZIP or foreign postal code imposed on you if taxable income results from this transaction Account number (see instructions) 6 Identifiable event code 7 Fair market value of property and the IRS determines that it has not been D $ reported. Form 1099-C (keep for your records) Department of the Treasury - Internal Revenue Service Example #2 Assume the same facts as Example #1, but the foreclosure and debt cancellation occur simultaneously on January 15, Pam does not receive Form 1099-A. Instead she receives only a 2014 Form 1099-C showing the following: Box 1: January 15, 2014 (date of identifiable event). Box 2: $25,000 (amount of debt discharged). Box 3: Blank, because the lender did not include interest in the box 2 amount. Box 4: Home mortgage loan. Box 5: Checked, if the loan was a recourse loan. Box 6: Code D, since the lender has decided to foreclose on the home rather than pursue collection of the loan Pam defaulted on. Box 7: $190,000 (fair market value of property). CORRECTED (if checked) CREDITOR'S name, street address, city or town, state or province, country, 1 Date of identifiable event OMB No ZIP or foreign postal code, and telephone no. 1/15/2014 Mortgage Lender 2 Amount of debt discharged Cancellation $ 25, of Debt 3 Interest if included in box 2 $ Form 1099-C CREDITOR'S federal identification number DEBTOR'S identification number 4 Debt description Copy B For Debtor DEBTOR'S name This is important tax Home mortgage loan information and is being Pam furnished to the Internal Revenue Service. If you are required to file a Street address (including apt. no.) 5 If checked, the debtor was personally liable for return, a negligence repayment of the debt X penalty or other sanction may be City or town, state or province, country, and ZIP or foreign postal code imposed on you if taxable income results from this transaction Account number (see instructions) 6 Identifiable event code 7 Fair market value of property and the IRS determines that it has not been D $ 190,000 reported. Form 1099-C (keep for your records) Department of the Treasury - Internal Revenue Service TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Chapter 1 9

15 NOTES Example #3 Assume the same facts as Example #1, but the house is worth $215,500 on the date of foreclosure. The fair market value of the house exceeds the outstanding loan amount so there is no debt cancellation and no Form 1099-C. Pam receives only a 2013 Form 1099-A showing the following information: Box 1: March 1, 2013 (date of foreclosure) Box 2: $215,000 (balance of principle outstanding) Box 4: $215,500 (fair market value of property) Box 5: Checked, if the loan was a recourse loan Box 6: Property address If the house loses value before the lender can sell it, there is no debt cancellation. CORRECTED (if checked) LENDER S name, street address, city or town, province or state, country, ZIP or foreign postal code, and telephone no. Mortgage Lender LENDER S federal identification number BORROWER S name Pam Street address (including apt. no.) BORROWER S identification number City or town, province or state, country, and ZIP or foreign postal code Account number (see instructions) OMB No Form 1099-A 1 Date of lender's acquisition or 2 Balance of principal knowledge of abandonment outstanding 3/1/2013 $ 215, Fair market value of property $ 215,500 5 If checked, the borrower was personally liable for repayment of the debt X 6 Description of property (address of home) Form 1099-A (keep for your records) Acquisition or Abandonment of Secured Property Copy B For Borrower This is important tax information and is being furnished to the Internal Revenue Service. If you are required to file a return, a negligence penalty or other sanction may be imposed on you if taxable income results from this transaction and the IRS determines that it has not been reported. Department of the Treasury - Internal Revenue Service In the first two examples, Pam has cancellation of debt in the amount of $25,000. The taxable amount, if any, depends on Pam s circumstances. Principal residence rules for tax consequences of the foreclosure and debt cancellation are discussed in Chapter 3, Foreclosures and Repossessions. Note: The fair market value amount provided by the lender in box 4, Form 1099 A, may not necessarily be correct. The taxpayer may benefit from obtaining a formal appraisal of the property as of the date of foreclosure or abandonment. 10 Chapter 1 TheTaxReview Foreclosures, Repossessions, and Cancelled Debt

16 Learning Objective 1-C Determine how to properly report income from cancelled debt on the tax return. NOTES Generally, if a taxpayer owes a debt to someone else and the debt is cancelled or forgiven for less than the full amount owed, the amount cancelled or forgiven is treated as income. The taxpayer may be required to include cancelled debt in gross income and pay tax on all or part of the cancelled debt. Exceptions and exclusions may apply. See Chapter 2, Cancelled Debt as Income, page 21, for more information on determining the amount of cancelled debt that must be included in gross income. If the debt being forgiven is part of a loan secured by property, the taxpayer may also have to recognize gain or loss. Key Fact Once the amount of cancelled debt that is includable in gross income has been determined, the nature of the debt dictates how the income will be reported on the tax return. The taxable amount must be reported whether or not the taxpayer receives Form 1099-C, Cancellation of Debt. Generally, if a taxpayer owes a debt to someone else and the debt is cancelled or forgiven for less than the full amount owed, the amount cancelled or forgiven is treated as income. Nonbusiness Debt If the cancelled debt is a nonbusiness debt, report the taxable amount as ordinary income on line 21, Form Recourse nonbusiness debt. The borrower is personally liable to repay recourse debt. Examples of recourse nonbusiness debt include nonbusiness credit card debt, consumer loans, and personal loans. Unless an exception or exclusion applies, the full amount cancelled or forgiven is reported on line 21, Form Nonrecourse nonbusiness debt. The borrower is not personally liable to repay nonrecourse debt. Generally, nonrecourse debt is secured by collateral that can be returned to the lender in full satisfaction of the loan. For example, a mortgage or a car loan could be a nonrecourse nonbusiness loan. When nonrecourse debt is forgiven, the borrower does not have ordinary income from the cancellation of the debt unless the borrower retains the collateral and one of the following is true. The lender offers a discount for the early payment of the debt, or The lender agrees to a loan modification that results in the reduction of the principal balance of the loan. TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Chapter 1 11

17 NOTES Example Jana owes $15,000 on her personal credit card and makes no attempt to pay the amount owed. After unsuccessfully attempting to collect, the credit card company cancels the debt and in 2014 issues Form 1099-C, Cancellation of Debt, in the amount of $15,000. Box 6 of Form 1099-C is marked with Code G, Decision or policy to discontinue collection. Jana determines that she does not qualify for any of the exceptions or exclusions (discussed in Chapter 2, Cancelled Debt as Income, page 21). She must report $15,000 of ordinary income on line 21 of her 2014 Form Example In 2012, Simon bought a motorcycle for his personal use from a dealer, who loaned him the full purchase price of $20,000. Simon is not personally liable for the debt, since his loan documents stipulate that the debt is fully secured by the motorcycle. The dealer needs quick cash and in 2014, offers Simon a $5,000 discount for paying off his motorcycle loan early. Simon agrees to the offer, pays off the loan on July 4, 2014, and keeps the motorcycle. He receives Form 1099-C, Cancellation of Debt, in the amount of $5,000. Box 6 of Form 1099-C is marked with Code F, By agreement. Unless Simon qualifies for one of the exceptions or exclusions discussed in Chapter 2, he must report $5,000 as ordinary income on line 21 of his 2014 Form Note: If Simon returns the motorcycle to the dealer rather than continue making payments, there is no cancellation of debt income because the loan was a nonrecourse loan. The amount of cancelled debt remains as part of Simon s basis in the motorcycle. Business Debt When debt incurred as part of a trade or business activity is cancelled, any taxable amount is reported on the form used by the business to report business income. Schedule C. If the cancelled debt is related to a nonfarm sole proprietorship, report the taxable amount as other income on line 6, Schedule C. Schedule E. If the cancelled debt is related to the nonfarm rental of real property, report the taxable amount with other rental income on line 3, Schedule E. Schedule F. If the cancelled debt is farm debt and the taxpayer is a farmer, report the taxable amount as other income on line 8, Schedule F. Form If the cancelled debt is related to a farm rental activity for which the taxpayer uses Form 4835, Farm Rental Income and Expenses, to report farm rental income based on crops or livestock produced by a tenant, report the taxable amount as other income on line 6, Form Chapter 1 TheTaxReview Foreclosures, Repossessions, and Cancelled Debt

18 Shareholder Debt Schedule B. When a corporation cancels or forgives debt owed to the corporation by a shareholder, the cancelled debt is a constructive dividend. The corporation cannot deduct the cancelled debt and the shareholder must report any taxable portion of the dividend on Schedule B, Interest and Ordinary Dividends. NOTES Example Jim operates his chiropractic business as a sole proprietorship. He purchased some equipment in 2012 for his business. In 2014, the remaining balance of the loan was cancelled. Unless he qualifies for one of the exceptions or exclusions discussed in Chapter 2, Cancelled Debt as Income, Jim must include the full amount of cancelled debt in his 2014 Schedule C income. His basis in the equipment for depreciation remains unchanged. Example Rick owns an airplane hangar, which he rents to the owner of a small plane. In 2011 he borrows $15,000 so that he can replace the concrete around the hangar. In 2014, his lender agrees to a loan modification and reduces the remaining principal by $5,000. Rick must increase his 2014 rental income by $5,000. Example Mary owns land which she leases to a tenant farmer in return for 35% of his crop proceeds. After the tenant s 2012 crop failures, Mary receives no income in 2013 and 2014 and is unable to make the payments on the farm. The lender forecloses on the land and cancels Mary s mortgage. After applying the exceptions and exclusions discussed in Chapter 2, Mary determines that she has $10,000 of taxable debt cancellation income. She must report $10,000 as other income on her 2014 Form Because Mary no longer owns her land, she must report the disposition as a taxable event, discussed next. Example Cathy is a shareholder in a C corporation. During 2011 and 2012 she borrowed money from the corporation. In 2014 the corporation wrote off the loans and cancelled Cathy s debt. Cathy determines that in her case, the entire amount is taxable, and reports the cancelled debt as dividend income on her 2014 Schedule B. Debt Cancellation and Sales or Other Dispositions of Property Securing the Debt Key Fact Cancellation of debt often occurs in connection with a foreclosure, repossession, abandonment, sale, or other disposition of the property that secures the debt. The lender s repossession or foreclosure of the property is treated as a sale of the property by the taxpayer. TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Chapter 1 13

19 NOTES When property subject to a debt is abandoned, the lender must foreclose on the property in order to acquire it. Foreclosure or repossession of property subject to recourse debt. If a lender repossesses or forecloses on property subject to a recourse debt and the remaining amount of the debt exceeds the FMV of the property at the time of the repossession or foreclosure, then: The gain or loss on the disposition of the property is measured by the difference between the FMV of the property at the time of the disposition and the adjusted basis (usually cost) in the property. The character of the gain or loss (ordinary income or capital gain income) is determined by the character of the property. If the lender forgives or cancels all or part of the amount of debt in excess of the FMV, the cancellation of the excess debt results in ordinary income for the borrower. The borrower reports any taxable portion of the debt cancellation income on line 21, Form 1040, or on Schedule C, E, or F, or on Form 4835 as explained above. See Chapter 2, Cancelled Debt as Income, page 21, for information about exceptions and exclusions that may apply. A gain or loss may be realized by the borrower. Gain or loss on the disposition of the property is the difference between the FMV at the time of the disposition and the borrower s adjusted basis in the property. Foreclosure or repossession of property subject to a nonrecourse debt. If a lender repossesses or forecloses on property subject to a nonrecourse debt and the remaining amount of the debt exceeds the FMV of the property at the time of the repossession or foreclosure, then: The foreclosure does not result in ordinary income from debt cancellation, even if the lender forgives all or part of the excess debt. The entire amount of the nonrecourse debt is treated as the amount realized on the disposition of the property. The gain or loss realized by the borrower is the difference between the total amount realized (entire amount of nonrecourse debt plus the amount of cash and the FMV of any property received) minus the borrower s adjusted basis in the property. The character of the gain or loss (ordinary or capital) is determined by the character of the property. See Chapter 3, Foreclosures and Repossessions, page 39, for more information on computing this gain or loss. Abandonment of property subject to a debt. When property subject to a debt is abandoned, the lender must foreclose on the property in order to acquire it. Then the above rules for foreclosure or repossession of property apply. If the debt is recourse debt and the amount in excess of the property s FMV is cancelled by the lender, the cancellation of the debt is ordinary income for the borrower. If the cancelled or forgiven debt is nonrecourse debt, there is no debt cancellation income. The borrower does not have gain or loss until the foreclosure is completed. If the debt was recourse debt, gain or loss is the FMV of the property minus the borrower s adjusted basis in the property. If the debt was nonrecourse debt, then the gain or loss is the entire amount of the outstanding debt minus the borrower s adjusted basis. Key Fact The character of the gain or loss (ordinary or capital) upon disposition of property securing a debt is determined by the character of the property. 14 Chapter 1 TheTaxReview Foreclosures, Repossessions, and Cancelled Debt

20 Personal-use property and investment property. Disposition of personaluse property or investment property securing a debt is reported on Form 8949, Sales and Other Dispositions of Capital Assets, and on Schedule D, Capital Gains and Losses. Gain or loss is determined using the rules explained above, depending on whether the property was subject to a recourse debt or a nonrecourse debt. The amount of capital loss may be limited. No loss is allowed from the abandonment, repossession, or foreclosure of personal-use property. See Chapter 3, Foreclosures and Repossessions, page 39, for more information on computing this gain or loss. NOTES Property used in a trade or business. If the foreclosed or abandoned property is business-use property, the taxpayer may be required to report the disposition as a sale on Form 4797, Sales of Business Property. Gain or loss is determined using the rules explained on page 14, depending on whether the property was subject to a recourse debt or a nonrecourse debt. Depreciation allowed or allowable and depreciation recapture must be considered. As with the sale of any property used in a trade or business, the resulting gain or loss may be ordinary income, capital gain, or a combination of the two. Example In 2011, Reid and Nick each buy real estate for $200,000. Reid s loan is a recourse loan, and Nick s loan is a nonrecourse loan. After two years, the FMV of each property has dropped to $110,000. Reid and Nick each owe $150,000 on their properties, and both are behind on payments. The banks foreclose on Reid and Nick, and their debts are cancelled in Reid and Nick make the following calculations. Step 1: Determine cancellation of debt income. Reid (Recourse loan) Nick (Nonrecourse loan) Debt owed... $ 150,000 Less FMV...($ 110,000) Ordinary income from cancellation of debt...$ 40,000 There is no debt cancellation income, since Nick s mortgage debt is nonrecourse. Reid must report $40,000 in 2014 debt cancellation income on: Line 21, Form 1040, if the property was personal-use or investment property, or Schedule C, E, or F, or Form 4835, if the property was used in a trade or business. If Reid qualifies for one of the exclusions or exceptions discussed in Chapter 2, Cancelled Debt as Income, page 21, his basis for gain/loss on the foreclosure is reduced by the amount of nonrecognized debt cancellation. continued on next page TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Chapter 1 15

21 NOTES Example continued Step 2: Determine gain/loss on foreclosure. Reid (Recourse loan) Nick (Nonrecourse loan) Sale proceeds (cancelled debt up to FMV of foreclosed property).$110,000 Basis*...($200,000) Loss on foreclosure...($90,000) Sale proceeds (full amount of cancelled debt)... $150,000 Basis*...($200,000) Loss on foreclosure... ($50,000) * Depreciation allowed or allowable is disregarded for this example. Both Reid and Nick realize a loss on the foreclosure. Depending on the use of the property, the loss may be: A nondeductible personal loss, or A capital loss on an investment reportable on From 8949 and Schedule D, or A loss on property used in a trade or business reportable on Form Note: When debt cancellation income is combined with gain/loss on the foreclosure, the net amount is the same whether the debt is recourse or nonrecourse. Recourse and nonrecourse debt considerations merely serve to allocate that net amount to different places on the tax return. 16 Chapter 1 TheTaxReview Foreclosures, Repossessions, and Cancelled Debt

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