Building Your Tax Knowledge

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1 Building Your Tax Knowledge Foreclosures & Debt Relief The 1099-A and C November, 2012 William Roos, EA

2 Table of Contents Foreclosures and Cancellation of Debt... 1 Introduction... 1 Types of Debt... 2 Cancellation of Debt... 3 Where to Report the COD Income... 4 Deficiency Judgment... 4 Redemption... 5 Methods of Surrender of Property by Borrower to Lender... 5 Short Sales How Are They Taxed? Relief Provisions Mortgage Forgiveness Debt Relief Act of 2007 (Hr 3648) Reduction of Tax Attributes Form Information Returns Tax Returns Involving Foreclosures A Summary Check the website periodically for updates to this manual and revised forms used to report cancellation of debt and foreclosure. Disclaimer: This manual is intended to provide a general overview of the tax laws. It is neither intended as an exhaustive report on the law or as legal advice on any particular situation and should not be used as a substitute for legal counsel. Copyright 2012, William Roos, EA 924 Oakmont Lane Waconia, MN roos@bigsky.net

3 Introduction Foreclosures and Cancellation of Debt Cancellations of debt by lenders often cause taxable income to the borrower. How can this be averted? The problems in this seminar will be avoided if the taxpayer pays cash for all investments. Real estate, though, is primarily purchased with a combination of equity financing (money from the taxpayer) and outside financing (money from banks, savings-and-loans or insurance companies). The higher the ratio of debt is to the equity (commonly called leverage), the higher the repayment of debt and chance of financial stress. Leverage may cause both financial and tax problems for the taxpayer when (not if) future problems occur, such as low occupancy, adjustable rate mortgages, falling real estate values. and other variables. The interest and principal payment may eventually be more than the taxpayer can pay back. There are a few terms that are commonly used in real estate foreclosures, and it is critical to understand them in order to understand foreclosures in general. The mortgage is an interest in real property, created in writing, which provides security for the payment of a debt (the money borrowed to purchase the property). The person who borrows money to purchase the property is called the mortgagor. The mortgagor gives a mortgage to the mortgagee, which is the person or business that lends money to the mortgagor to buy the property. Throughout this seminar, the mortgagor is called the borrower or taxpayer, and the mortgagee is called the bank. The mortgage is called debt, loan, or mortgage, depending on the context in which it is used. Settlement of a mortgage debt at a discount may create cancellation of debt income for the borrower. On the other hand, if the lending institution is not willing to settle the debt voluntarily, foreclosure generally occurs and the borrower has essentially a taxable sale. Even a voluntary transfer to avoid foreclosure is considered a taxable sale. Bankruptcy, insolvency provisions and the new mortgage relief act soften the income tax created. Borrowing starts out nontaxable. Often taxpayers borrow a substantial portion of the funds when purchasing real estate. It also is common to refinance real estate to enable the taxpayer to pull out the equity. These economic benefits received by the taxpayer are not taxable as there is a future obligation to repay the debt, even when the mortgage is in excess of the basis [Woodsam v. Comm., 198 F2d 357 (2nd Cir. 1952)]. Example: Cathy bought her home for $80,000 cash in The home is now worth $130,000, and she takes out a refinanced loan of $110,000. Even though she has immediate use of $30,000 more in cash than her original investment, no gain is realized at the time of the loan as she must repay the entire amount in the future. The loan is part of the sales price. If later this debt obligation is partially or totally eliminated (most commonly by a sale), the borrower then enjoys an economic benefit related to the earlier receipt of the money. The borrower is not being required to repay all the cash received, which, in theory, increases the taxpayer s net worth. When property is sold, the sales price is the cash, other property received and the amount of the unpaid liability, even if the liability debt is a nonrecourse mortgage involving no personal risk [ 1001(b); (a); Crane v. Comm., 47-1 USTC 9217, 331 U.S. 1; Estate of Franklin v. Comm., 544 F2d 1045 (9th Cir. 1976)]. Example (continued): If Cathy later sells the property for $130,000 (payable with $20,000 in cash and assumption of the $110,000 mortgage), her sales price includes both the cash and the assumed mortgage. Thus, Cathy s gain is $50,000 ($130,000 sale price less her original $80,000 purchase price), even though she only will receive $20,000 in cash. William Roos, EA 1 Foreclosures & Cancellation of Debt

4 A mortgage placed on property after purchase does not increase the owner s basis [Woodsam v. Comm., 198 F2d 357 (2nd Cir. 1952)]. A mortgage is not a taxable event. Many taxpayers think that the amount of the mortgage determines the gain or loss on a property. A settlement of a loan at a discount may create income. This can occur either as a gain at time of sale or as cancellation of debt (COD) income [ 1001(b); 61(a)(12)]. When is a loan cancellation a sale? When it is in connection with the surrender of the property. When property is deeded to a secured lender in satisfaction of the debt, this is considered, in whole or in part, a taxable sale (as discussed later). Example - Sale: Cathy buys her home for $80,000 cash in When the home is worth $130,000, she takes out a refinanced loan of $110,000. The property subsequently reduces in value to $85,000 and she talks the lending institution into accepting a deed-in-lieu-of-foreclosure (i.e., the bank forgives the $110,000 current mortgage if Cathy voluntarily deeds the property to the bank.) In this case, Cathy has a taxable sale that may be accompanied by cancellation of debt income, even though she has no assets to pay the taxes associated with this sale! When is a loan cancellation COD income? To many taxpayers surprise, any reduction in the principal amount of the debt at the time of, or prior to, sale or exchange may result in cancellation-of-indebtedness income [ 61(a)(12)]. Example - Prudent financial planning with a nasty tax result. Cancellation-of-debt income is most common when the taxpayer wishes to prepay a mortgage at a discount (i.e., for less than the principal balance of the mortgage). Most taxpayers erroneously think this is simply a reduction in the original purchase price. In many cases the taxpayer realizes COD income, whether the mortgage is recourse or nonrecourse and whether it is partially or fully prepaid [Rev. Rul , CB 35]! Some COD income dodges tax. Whether this realized income converts to taxable income depends on a number of factors. Some COD income escapes taxation by exclusions mentioned later. Types of Debt The type of debt involved in a foreclosure determines what amounts the taxpayer will report for the foreclosure and foreclosure sale, and whether the amounts are reported as gain or loss. The type of debt also determines whether the taxpayer is personally liable to the bank for any part of the debt that is not satisfied by the sale of the property. This is called a deficiency, and it is discussed in greater detail later. Recourse Debt. Recourse debt is that for which the borrower is personally liable. The borrower must pay any amount in excess of the debt satisfied by surrender of property unless the bank voluntarily, or by order of a bankruptcy court, forgives the unpaid amount as uncollectible. The surrender of property to satisfy a recourse debt is treated as a sale, which may create ordinary income or loss for the borrower. In a case where the borrower defaults on a recourse loan, the bank may attempt to collect the debt against the property that was the security for the loan, and the borrower's income and personal assets. However, the bank is usually required to obtain permission from a court before attempting to collect against the borrower's personal assets. This procedure is discussed later. William Roos, EA 2 Foreclosures & Cancellation of Debt

5 Nonrecourse Debt. Nonrecourse debt is that for which the borrower is not personally liable. This means that if the borrower defaults on the loan, the bank may only look to the collateral to satisfy the debt. The bank still has the right to foreclose on the mortgage that secures the debt, but does not have the right to seek payment from the borrower personally for any part of the debt. Accordingly, while the transfer of property to satisfy a nonrecourse loan is treated as a sale, it does not result in cancellation of debt income for the borrower. NOTE: Where do you find whether a mortgage or note is recourse or nonrecourse? Generally you will not find it in the fine print. Look in the signature block where the lender signs the document. See the illustration to the right. As you can see, this note is without recourse or a nonrecourse mortage. If in doubt, do not guess. Make the client find out. Although calculation of gain and loss in foreclosure are discussed in more detail later, it is necessary to mention a few points about this subject now. For both recourse and nonrecourse loans, gain or loss is calculated by comparing the borrower s adjusted basis in the property with the amount considered to be received in the foreclosure. The amount is considered to be received because the borrower is treated as if he or she actually received the sale proceeds, when he or she usually does not. The difference in calculating gain or loss for recourse and nonrecourse loans lies in what makes up the amount considered to be received. For nonrecourse loans, it is the amount of the debt canceled. For recourse loans, it is the amount of the debt canceled, but limited by the fair market value of the property. There are two primary reasons why a debt is classified as recourse or nonrecourse. The first is that many states require, by statute, that certain kinds of debt are nonrecourse, which has the effect of placing the risk of loss on the seller. The policy underlying this requirement is that the seller is in a better position to manage the impact of nonrecourse defaults by charging the buyer points, requiring a large down payment, or by charging a higher rate of interest for nonrecourse loans. The second reason is that the borrower and lender agree on a type of debt. Cancellation of Debt General rule: Cancellation of debt creates income. An taxpayer s gross income, for tax purposes, includes income from discharge of indebtedness, or cancellation of debt, in addition to the more common sources of income, such as salaries and commissions [ 61(a)(12)]. Taxable ordinary income. Cancellation of indebtedness income is taxable ordinary income and results when any of the borrower s debt is reduced (by compromise, negotiation or otherwise) for less than the full amount due. COD income commonly comes from restructuring or settling a loan [U.S. v. Kirby Lumber Co., 284 U.S. 1 (1931)]. COD income creates a tax problem for the solvent borrower. As discussed previously, the solvent borrower generally is subject to an immediate tax from the income created by the cancellation of debt. The problem is that this reduction in mortgage debt does not produce the immediate cash flow necessary to pay the tax associated with this phantom income. Example - Reduction in debt. Instead of transferring the property to the Last Chance Savings & Loan, Cathy talks the lending institution into reducing the $110,000 refinanced debt to the fair market value of $85,000, with the promise that Cathy will restart making her monthly payments. In this William Roos, EA 3 Foreclosures & Cancellation of Debt

6 scenario, Cathy has received a $25,000 economic benefit and still has possession of the property. Therefore, she has a $25,000 COD income tax problem (unless an exclusion applies). Forgiveness of nonrecourse debt reduction in purchase price. If a solvent taxpayer buys a property from a seller with a nonrecourse note and then later the seller reduces the mortgage, this is a reduction in the purchase price and no cancellation of debt income results. Note that the seller must be the one to reduce the mortgage. If the seller has sold the mortgage to a third party and they reduce the mortgage, then there is cancellation of debt income [ 108(e)(5)]. Forgiveness of nonrecourse debt also creates COD income not reduction in purchase price. The lender s reduction of the principal amount of an unsecured nonrecourse loan (i.e., the borrower is not personally liable on the note and the lender looks to the property for security) results in COD income, not a purchase price reduction. The fair market value of the property is irrelevant when determining COD income or purchase price reduction [Rev. Rul , IRB ]. In a 1934 case involving nonrecourse financing, the court decided that subsequent reduction in the debt would be a purchase price reduction and therefore not create an immediate income. Presently, the courts and the IRS disagree on this point [Fulton Gold Corp. v. Comm., 31 BTA 519 (1934)]. Example: In 2008, wealthy Fran purchases an office building from Kukla for $1,000,000, borrowing the entire amount from Pioneer Federal S&L with a nonrecourse note (i.e., Fran has no personal liability with respect to the note) secured by the office building. In 2010, when the property s fair market value is $800,000 and the outstanding principal on the note is still $1,000,000, Pioneer agrees to reduce the note to $800,000. The $200,000 is taxable as COD income to Fran in 2010 (not a reduction in the purchase price) unless she is bankrupt or insolvent. Where to Report the COD Income A frequent question is where to report the COD income on the tax return. Some references say to report it on line 21 of Form Publication 525, Taxable and Nontaxable Income, says to report any debt forgiveness from a business on Schedule C or from a farm on Schedule F. The IRS is silent on reporting COD income from rental properties which would imply it goes on Line 21. However, other references say to put it on Schedule E which would turn it into passive income. In the end it really would not make much difference as any suspended passive losses can be deducted in the year the property is disposed of and so the AGI would be the same either way. Deficiency Judgment If real property is sold at a foreclosure sale for an amount greater than or equal to the amount of the mortgage, the debt is satisfied and the obligation of the borrower, with respect to the debt, usually terminates. However, if the proceeds from sale are less than the amount of the mortgage, the bank can ask the court to issue a deficiency judgment. This judgment allows the bank to attempt to collect the unpaid amount of the mortgage debt from the borrower's income and other assets. Deficiency judgments are available only where the debt is recourse, because the deficiency judgment allows the bank to attempt to collect the deficiency from the borrower's income and personal property. Anti-deficiency statutes. Some states have anti-deficiency statutes which prevent the bank from seeking and enforcing a deficiency judgment. California and Arizona are two states where anti-deficiency statutes figure prominently in real estate financing. Although it may appear that an anti-deficiency statute would operate to transform recourse debt into nonrecourse debt (because the bank cannot collect against the borower personal- William Roos, EA 4 Foreclosures & Cancellation of Debt

7 ly), this is not the case for taxation purposes. Gain, loss, and income on the foreclosure of recourse debt in a state with an anti-deficiency statute is computed the same as for other states where deficiencies are allowed. There is no ordinary COD income until the liability is released. What happens if the lending institution exercises its right to recover, via a deficiency judgment, for the unrecovered portion? In this situation the lender does not release the owner from liability and decides to collect the deficiency. This results in the borrower s not having COD income unless, and until, the debt is discharged. If the lender fails to pursue the borrower or to discharge all the indebtedness, debt discharge income results when the statute (under state law) for enforcing the debt expires. Redemption Equity of Redemption. Buyers of real property have many centuries-old rights which serve to protect their property rights. The most significant of these is the right of redemption, which enables the buyer, and sometimes related parties, to stop the foreclosure proceedings by purchasing the property in full from the time after default until after the foreclosure is complete. Redemption takes two forms, the first of which is the equity of redemption. The equity of redemption allows the buyer to redeem his or her real property after default on the mortgage, all the way until the property is sold at a foreclosure sale. In order to save the property by redemption, the buyer must pay the underlying debt, plus interest and other costs, such as those incurred in listing the property for sale, and legal costs. If the original buyer does not or cannot redeem the property, his or her equity of redemption is terminated. The seller then takes the proceeds of sale and applies them to the mortgage debt, and the new buyer takes the property free of the original buyer's right to redeem. The equity of redemption is available to all buyers in all states. Statutory Redemption. Statutory redemption is available to buyers in many states, and allows buyers and related parties to redeem only after the foreclosure sale. Statutory redemption is accomplished by paying the foreclosure sale purchaser the foreclosure sale price, plus additional amounts, such as fees or costs incurred by the foreclosure sale purchaser. Note: Remember that the right of the original buyer to redeem by exercising the equity of redemption arises after default, and terminates when the property is sold. The statutory right of redemption arises after the foreclosure sale, and runs for a specific period of time, which is determined by statute. Methods of Surrender of Property by Borrower to Lender Property commonly is surrendered by a borrower to a lender by the following methods: Foreclosure Deed in lieu of foreclosure Repossession Abandonment Foreclosure A Forced Surrender of Property by the Borrower to the Lender Definition. When a borrower fails to pay a mortgage on time, the lender generally starts legal proceedings to sell the property securing that debt. This involuntary sale normally causes adverse tax ramifications to the borrower. Debt relief causes transfer of property to be a sale and sale creates a gain (or loss). A foreclosure, even though the taxpayer has no choice, is a sale for tax purposes (it is not a gift from the borrower back to the lender!) [G. Hammel v. Helvering, SCt, (rev g CA-6), 41-1 USTC 9169, 311 U.S. 504, 61, S. Ct 368]. William Roos, EA 5 Foreclosures & Cancellation of Debt

8 Review on calculating gain. As with any sale, the gain or loss is calculated by subtracting the taxpayer s adjusted basis from the amount realized. Personal liability (recourse debt) versus nonpersonal liability (nonrecourse debt). Strangely, the amount realized, which is usually the debt forgiven in these situations, may be different, depending on whether the taxpayer is personally liable on the mortgage (i.e., a recourse mortgage) or not personally liable on the mortgage (i.e., a nonrecourse mortgage) [J. G. Abramson, CA-2, 42-1 USTC 9200, 124 F2d 416]. A Foreclosure When the Borrower Is Personally Liable (A Recourse Mortgage) Requires a Two-step Calculation. Generally the deemed sales price when a recourse mortgage is turned back to the lender is the actual debt relief as a result of the foreclosure. But this sales price cannot include any COD income. Therefore, a foreclosure involving a recourse debt must be divided into two parts: (1) gain (or loss) created by foreclosure and (2) income from the discharge of indebtedness [ (a)(2), and (c)(example 8); Rev. Rul , CB 12; Bressi v. Comm., TC Memo , 62TCM 1668]. The income on the surrender of secured property in exchange for the discharge of recourse debt is calculated as follows: Step 1. COD income. The excess of the amount of the debt discharge over the property s fair market value, if any, is income from the discharge of indebtedness (ordinary income). This is the only amount that may be sheltered by bankruptcy and insolvency relief provisions. Of course, there is no COD income if the borrower remains liable for the deficiency [ (a)(2); Rev. Rul , CB 12]. Step 2. Gain or loss from foreclosure. The sales price (or fair market value when there is no sale) of property surrendered less the property s adjusted basis is the gain or loss from the disposition of property. The formula when surrendering secured property in exchange for the discharge of recourse debt is as follows: Part 1. Figure the taxpayer s income from cancellation of debt. (NOTE: If the taxpayer is not personally liable for the debt, as with a nonrecourse debt, the taxpayer does not have income from cancellation of debt. Skip Part 1 and go to Part 2.) 1. Enter the amount of debt cancelled by the transfer of property 2. Enter the fair market value of the transferred property 3. Income from cancellation of debt. Subtract line 2 from line 1. If less than zero, enter zero. Part 2. Figure the taxpayer s gain or loss from foreclosure or repossession 4. Enter the smaller of line 1 or line 2. Also include any proceeds the taxpayer received from the foreclosure sale. (If the taxpayer is not personally liable for the debt, enter the amount of debt canceled by the transfer of property.) 5. Enter the adjusted basis of the transferred property 6. Gain or loss from foreclosure or repossession. Subtract line 5 from line 4. Example - Recourse debt: Sharon purchased property for $85,000 with an $80, year mortgage (recourse debt). After eight years, she has accumulated depreciation of $35,000, leaving her an adjusted basis of $50,000, but she has paid down the mortgage to only $75,000. Life is tough and Sharon stops making payments. The lending institution forecloses, the property is sold at sheriff s William Roos, EA 6 Foreclosures & Cancellation of Debt

9 sale for $60,000 and the lending institution forgives the remaining amount due as it determines there tain t no blood left in that turnip. Even though Sharon is broke, the IRS doesn t care she has both capital gain and ordinary income. Part 1. Figure the taxpayer s income from cancellation of debt. (NOTE: If the taxpayer is not personally liable for the debt, as with a nonrecourse debt, the taxpayer does not have income from cancellation of debt. Skip Part 1 and go to Part 2.) 1. Enter the amount of debt cancelled by the transfer of property $ 75, Enter the fair market value of the transferred property 60, Income from cancellation of debt. Subtract line 2 from line 1. If less than zero, enter zero. 15,000 Part 2. Figure the taxpayer s gain or loss from foreclosure or repossession 4. Enter the smaller of line 1 or line 2. Also include any proceeds the taxpayer received from the foreclosure sale. (If the taxpayer is not personally liable for the debt, enter the amount of debt canceled by the transfer of property.) $ 60, Enter the adjusted basis of the transferred property 50, Gain or loss from foreclosure or repossession. Subtract line 5 from line 4. 10,000 Tax tip: Only the COD income can be offset if Sharon is bankrupt or insolvent. The new mortgage relief act will not help Sharon since this is rental property. She still is taxed on the $10,000 gain. In this case it will be section 1250 depreciation recapture gain. A Foreclosure When the Borrower Is Not Personally Liable (A Nonrecourse Mortgage) Requires Only a One-step Approach. In a nonrecourse debt, the lending institution looks only to the property for recovery of the mortgage and cannot additionally look to the borrower s other assets. In effect, the taxpayer never owes more than the fair market value of the asset securing the loan. Therefore, the sales price is the entire nonrecourse debt regardless of the fair market value. The result is that there will never be COD income in a foreclosed nonrecourse debt [ (b); Comm., v. John F. Tufts, SCt, 83-1 USTC 9328, 461 U.S. 300 (1983)]. The gain on the surrender of secured property in exchange for the discharge of nonrecourse indebtedness is calculated as follows: Step 1: Gain or loss from foreclosure (the one and only step). Subtract the adjusted basis from the mortgage relief. Foreclosure results in income to the borrower when the mortgage forgiven exceeds the borrower s adjusted basis in the secured property [ (c)(7); 7701(g)]. Example- Nonrecourse debt: Sharon purchases property for $200,000 with a $200,000, 30-year mortgage (nonrecourse debt). After eight years she has accumulated depreciation of $35,000, leaving her an adjusted basis of $165,000, but she has paid down the mortgage to only $190,000. Life is tough and Sharon stops making payments. The lending institution forecloses and the property is sold at a sheriff s sale for $150,000 (which is irrelevant as Sharon is not personally responsible for any deficiency judgment). In Sharon's case, the seller cannot attempt to collect any remaining debt on the mortgage from her income or personal assets, because the loan was nonrecourse. Upon default, Sharon William Roos, EA 7 Foreclosures & Cancellation of Debt

10 will lose the property, but she may also walk away from the debt, without concern that the seller may attempt to seize her personal assets or garnish her wages. The formula when surrendering secured property in exchange for the discharge of nonrecourse debt is as follows: Part 1. Figure the taxpayer s income from cancellation of debt. (NOTE: If the taxpayer is not personally liable for the debt, as with a nonrecourse debt, the taxpayer does not have income from cancellation of debt. Skip Part 1 and go to Part 2.) 1. Enter the amount of debt cancelled by the transfer of property $ 190, Enter the fair market value of the transferred property 3. Income from cancellation of debt. Subtract line 2 from line 1. If less than zero, enter zero. Part 2. Figure the taxpayer s gain or loss from foreclosure or repossession 4. Enter the smaller of line 1 or line 2. Also include any proceeds the taxpayer received from the foreclosure sale. (If the taxpayer is not personally liable for the debt, enter the amount of debt canceled by the transfer of property.) $ 190, Enter the adjusted basis of the transferred property 165, Gain or loss from foreclosure or repossession. Subtract line 5 from line 4. 25,000 Comment: The calculation is the same even if the property is voluntarily transferred by a deed in lieu of foreclosure, discussed later [ (c)(7)]. Character of the gain or loss in a foreclosure. Foreclosure gain or loss is governed by the normal gain or loss rules; that is, a capital asset creates a capital gain or loss, business assets create capital gain and ordinary loss, and dealer realty creates ordinary gain and loss. Tragically, foreclosure on a personal residence may create a taxable gain or a nondeductible loss! The section 121 exclusion rule is available. Under the Mortgage Forgiveness Debt Relief Act of 2007 (discussed later), any debt forgiven on a personal residence may be excluded from income under the new rules. Then, if section 121 is applicable, any gain from the sale is not taxed. The taxpayer really wins in this situation. But what if they do not meet the 2 of 5 year rule for ownership and use? This question has come up many times in the recent subprime mortgage mess where taxpayers were forced out of their homes in 6 to 18 months after buying them. Can the unforeseen circumstances rule be applied? Facts and circumstances. A taxpayer who does not qualify for one of the safe harbor rules may still demonstrate that the primary reason for the sale is unforeseen circumstances, under a facts and circumstances test, but only if the primary reason for the sale is unforeseen circumstances ( (b)). Factors that may be relevant to the IRS in determining the taxpayer's primary reason for the sale include (but are not limited to) the extent to which: the sale and the circumstances giving rise to the sale are proximate in time; the suitability of the property as the taxpayer's principal residence materially changes; the taxpayer's financial ability to maintain the property is materially impaired; the taxpayer uses the property as the taxpayer's residence during the period of ownership of the property; the circumstances giving rise to the sale are not reasonably foreseeable when the taxpayer begins using the property as the taxpayer's principal residence; and William Roos, EA 8 Foreclosures & Cancellation of Debt

11 the circumstances giving rise to the sale occur during the period of the taxpayer's ownership and use of the property as the taxpayer's principal residence. In looking at either the examples in the regulations or the letter rulings that have been issued, it is obvious that the loss of a job, unexpected rise in interest rates, and the misrepresentations by some mortgage companies would qualify as an unforeseen circumstance. But what about the taxpayer who just over extends himself because he purchases too many toys, i.e. boats, snowmobiles, motorcycles, etc. Just plain old money mismanagement. It is doubtful that those situations would qualify for unforeseen circumstances because running up his debt was not outside his control. A judgment call the tax practitioner will have to make. Year to report the gain or income. Gain or loss on foreclosure is generally reportable in the year the foreclosure sale and debt discharge takes place unless state law allows the borrower a right-of-redemption period (e.g., one-year right of redemption). Then the gain is reported after the right-of-redemption period lapses [William A.Belcher, Jr. v. Comm., 24 TCM 1; TC Memo ; Derby Realty Corp. v. Comm., 35 BTA 335 (1937)]. Tax tip: If the taxpayer needs the loss, or can use the gain in a specific tax year, this loss can be deferred or accelerated by voluntarily quitclaiming his or her right of redemption to the lender [Atmore Realty Co., BTA Memo, Dec. 12,517-A, April 30, 1942]. Deed in Lieu of Foreclosure A Voluntary Transfer of Property to the Lending Institution Definition. In a deed in lieu of foreclosure, a borrower voluntarily delivers the property deed to the lender before the lender starts foreclosing on the property (normally to avoid the embarrassment and/or the legal fees involved in a foreclosure). It is a taxable sale. A voluntary transfer by a deed in lieu of foreclosure is a sale for tax purposes sometimes much to the surprise of the borrower [ (a)(4)(iii); Rev. Rul , CB 264; Rev. Rul , CB 12]. Recourse debt. Similar to a foreclosure, a deed in lieu of foreclosure involving a recourse debt must also be divided into two parts: (1) gain (or loss) created by the transfer and (2) income from the discharge of indebtedness [ (a)(2); Rev. Rul , CB 12]. The two-step approach formula. The income on the surrender of secured property in exchange for the discharge of recourse indebtedness is the same as is used in a foreclosure (previously discussed). Tax tip: When the taxpayer is insolvent (or bankrupt), keep the capital gain on sale (step 2) low and the COD income (step 1) high. COD income may end up being excluded from income. The gain on sale might be taxable However, it might also work to the taxpayer advantage to get as much gain on the capital side especially if the section 121 exclusion is available. How? This may be done by obtaining a credible low fair market value appraisal of the surrendered property. This tax tip requires planning by the taxpayer before they tell their preparer of a done deal. Every client should be warned to talk to their tax preparer before they do anything that affects their finances. Example - Recourse debt. As in the prior example, Sharon finds herself owing $75,000 on a property worth $60,000 that has an adjusted basis of $50,000. Instead of Sharon s going through foreclo- William Roos, EA 9 Foreclosures & Cancellation of Debt

12 sure proceedings, she agrees to voluntarily transfer the property by a deed in lieu of foreclosure. If her FMV is increased by $10,000, then her COD income is only $5,000 but her capital gain is $20,000. On the other hand, if she is insolvent, then get the COD income as high as possible to reduce the taxable capital gain. Part 1. Figure the taxpayer s income from cancellation of debt. (NOTE: If the taxpayer is not personally liable for the debt, as with a nonrecourse debt, the taxpayer does not have income from cancellation of debt. Skip Part 1 and go to Part 2.) 1. Enter the amount of debt cancelled by the transfer of property $ 75, Enter the fair market value of the transferred property 70, Income from cancellation of debt. Subtract line 2 from line 1. If less than zero, enter zero. 5,000 Part 2. Figure the taxpayer s gain or loss from foreclosure or repossession 4. Enter the smaller of line 1 or line 2. Also include any proceeds the taxpayer received from the foreclosure sale. (If the taxpayer is not personally liable for the debt, enter the amount of debt canceled by the transfer of property.) $ 70, Enter the adjusted basis of the transferred property 50, Gain or loss from foreclosure or repossession. Subtract line 5 from line 4. 20,000 Tax tip: If the fair market value is low enough, this can create a deductible capital loss, or even a 1231 fully deductible loss with the accompanying increase of COD income being completely excluded by the bankrupt or insolvent taxpayer! Example; Deed in lieu of foreclosure on land and building. Rob bought a commercial building on January 2, 2007 for $500,000. He financed the purchase with a $450,000 recourse bank loan and a $50,000 cash down payment. Each year, $5,000 in principal is due. The purchase price was allocated $50,000 to land and $450,000 to the building. During , Rob paid $5,000 of principal each year. During the first half of 2010, he paid $2,500 of principal and then ceased making payments because of financial difficulties. Thus, as of December 31, 2010, the outstanding debt principal was $432,500, and his adjusted basis in the building and land (after depreciation) was $405,250 ($355,250 in building and $50,000 in land). Rob transferred the property deed to the bank in lieu of foreclosure on December 31, 2010, and the bank discharged him from any further liability on the loan. The FMV of the property on December 31, 2010 was $400,000 ($60,000 allocated to land and $340,000 allocated to building). Rob was not bankrupt or insolvent at the time and did not make the qualified real property business debt election. Part 1. Figure the taxpayer s income from cancellation of debt. (NOTE: If the taxpayer is not personally liable for the debt, as with a nonrecourse debt, the taxpayer does not have income from cancellation of debt. Skip Part 1 and go to Part 2.) 1. Enter the amount of debt cancelled by the transfer of property $ 432, Enter the fair market value of the transferred property 400, Income from cancellation of debt. Subtract line 2 from line 1. If less than zero, enter zero. 32,500 Part 2. Figure the taxpayer s gain or loss from foreclosure or repossession 4. Enter the smaller of line 1 or line 2. Also include any proceeds the taxpayer received from the foreclosure sale. (If the taxpayer is not personally liable for the debt, enter the amount of $ 400,000 William Roos, EA 10 Foreclosures & Cancellation of Debt

13 debt canceled by the transfer of property.) 5. Enter the adjusted basis of the transferred property 405, Gain or loss from foreclosure or repossession. Subtract line 5 from line 4. $ (5,250) Comment: As is frequently the case, by the time a problem like this reaches the tax preparer s desk, the transaction is a done deal. Most clients will not know the breakout between the land and the building. How can it be determined? Take the percent of the land value from the purchase price and apply the same percent to the sales price. The purchase price percent for the land was 10% and so the sales price of the land would be $40,000. There is a net loss and so the loss should be allocated between the land and building in the same percent as the purchase [price allocation 90% to the building and 10% to the land. What was the building insured for? Generally, the insured value is an indicator of what the building is worth and the rest is for the land. County tax records might have the land listed separately. Tax practitioners should never suggest a figure for the land value. That is the client s responsibility. Where is this transaction reported? The building and the land would be reported on Form The $32,500 COD income will be reported: On Form 982 if Rob is insolvent (discussed later). On Form 1040, line 21 if the building is just being rented. On Schedule C if the building is being used in Rob s trade or business which makes it subject to SE tax. Tax Tip: A taxpayer who deeds business real property to a lender and has debt discharged may be eligible to make the election for real property business debt. This topic is not covered in this paper due to its complexity. For more details, see code section 108(c)(3). Example: Lender pursues borrower for deficiency after foreclosure. Assume the same facts as in the Example above except the bank seizes the property on December 31, 2010 and sues Rob for the $32,500 deficiency (debt of $432,500 - FMV of the seized property of $400,000). Here, Rob still has a 2010 Section 1231 loss of $5,250 on the deemed sale of the property to the bank for its FMV of $400,000. However, he has no debt discharge income until his $ deficiency is settled for less than full value-if that occurs. Thus, until resolution, the $32,500 deficiency is an open transaction. Comment: Lenders often obtain judgments against borrowers that include unpaid interest, attorneys' fees, and other costs in addition to the unpaid mortgage principal. These costs may be included on a Form 1099-C issued by the lender reporting the cancellation of indebtedness. For cash-basis taxpayers, deductions generally have not been claimed for these additional amounts so there is no debt discharge income if these amounts are cancelled. Thus, these amounts normally do not affect the computation of gain or loss on foreclosure. However, if all or part of the foreclosure proceeds are applied first to these additional costs (before being applied to principal), these costs may impact the computation of gain or loss. In this situation, the taxpayer may be entitled to deductions for costs (e.g., interest) deemed paid by the foreclosure proceeds. Nonrecourse debt. As discussed previously, the rules generally are the same as for foreclosures, that is, the transaction is treated as a sale. William Roos, EA 11 Foreclosures & Cancellation of Debt

14 Losses are possible. If the adjusted basis of the property exceeds the amount realized at time of transfer, there is a loss if the property is help for a trade or business or for investment [Rev. Rul , CB 372; E. Harris, 34 TCM 597, TC Memo, ]. Example: Deeding back land in satisfaction of nonrecourse debt. Frank purchased a parcel of land on July 1, 2007 for $320,000. He paid $32,000 down, with the balance due to the seller under a nonrecourse "contract for deed" arrangement. Annual payments of $10,000 of principal, plus interest, are due each July 1. Frank made the payments on July 1, 2008 and July 1, However, he determined in July 2010 that it was not beneficial for him to continue to make payments on the land; his outstanding debt on the land was $268,000, and its value was only $200,000. Frank agreed to transfer the land back to the seller in full satisfaction of the debt. Part 1. Figure the taxpayer s income from cancellation of debt. (NOTE: If the taxpayer is not personally liable for the debt, as with a nonrecourse debt, the taxpayer does not have income from cancellation of debt. Skip Part 1 and go to Part 2.) 1. Enter the amount of debt cancelled by the transfer of property $ 268, Enter the fair market value of the transferred property 3. Income from cancellation of debt. Subtract line 2 from line 1. If less than zero, enter zero. Part 2. Figure the taxpayer s gain or loss from foreclosure or repossession 4. Enter the smaller of line 1 or line 2. Also include any proceeds the taxpayer received from the foreclosure sale. (If the taxpayer is not personally liable for the debt, enter the amount of debt canceled by the transfer of property.) $ 268, Enter the adjusted basis of the transferred property 320, Gain or loss from foreclosure or repossession. Subtract line 5 from line 4. $ (52,000) Example: Deeding back depreciable real estate in satisfaction of nonrecourse debt. Jennifer purchased an apartment building in She financed the entire purchase with a $500,000 nonrecourse loan from Bucks Savings. By the end of 2010, the land and building had an adjusted tax basis of $350,000, and the building was experiencing negative cash flow. Jennifer could not continue to fund the negative cash flow, and on December 31, 2010 she deeded the building back to Bucks. At the time of the transfer, the nonrecourse loan principal balance was $497,000. Jennifer was insolvent as of December 31, Part 1. Figure the taxpayer s income from cancellation of debt. (NOTE: If the taxpayer is not personally liable for the debt, as with a nonrecourse debt, the taxpayer does not have income from cancellation of debt. Skip Part 1 and go to Part 2.) 1. Enter the amount of debt cancelled by the transfer of property $ 497, Enter the fair market value of the transferred property 3. Income from cancellation of debt. Subtract line 2 from line 1. If less than zero, enter zero. Part 2. Figure the taxpayer s gain or loss from foreclosure or repossession 4. Enter the smaller of line 1 or line 2. Also include any proceeds the taxpayer received from the foreclosure sale. (If the taxpayer is not personally liable for the debt, enter the amount of debt canceled by the transfer of property.) $ 497,000 William Roos, EA 12 Foreclosures & Cancellation of Debt

15 5. Enter the adjusted basis of the transferred property 350, Gain or loss from foreclosure or repossession. Subtract line 5 from line 4. $ 147,000 Repossession Note: When property is deeded back in a foreclosure transaction and the related debt is nonrecourse, the FMV of the property does not affect the tax consequences of the transaction. The deemed gain or loss on sale is based on the loan balance and the adjusted basis of the property. Ignoring any land values, Jennifer has $147,000 of section 1250 depreciation recapture at 25% tax rate. Repossession is the act of taking back property from a buyer who has failed to make payments when due. Is it a forced taking? If repossession amounts to an involuntary transfer of the property by the secured creditor, which is most often the case, the tax consequences to the borrower are the same as those outlined in the foreclosure section. Or is it a voluntary transfer? If, on the other hand, repossession amounts to a voluntary surrender of property by a borrower to the secured creditor, the tax consequences parallel those for the deed in lieu of foreclosure. Abandonment A Voluntary Surrender of Property by the Borrower Abandonment occurs when an taxpayer voluntarily surrenders possession of real estate without vesting this interest in any other person. Is an abandonment treated like a sale or exchange? Early case law indicated that certain abandonments were not sales and might result in an ordinary loss [W. W. Hoffman, CA-2, , 117 F2d 987]. An abandonment is treated like a sale. Recent Tax Court cases find that a sale occurs when property is abandoned and that a capital loss, rather than an ordinary loss, results for the borrower [E. L. Freeland, 74 TX 970, CCH Dec ; M. L. Middleton, 77 TC 310, CCH Dec. 38,124, aff d CA-11, 693 F2d 124, 82-2 USTC 9713; L. J. Arkin, 76 TC 1048, CCH Dec. 38,017; J. W. Yarbo, CA-5, 84-2 USTC 9691, aff g 45 TCM 170, CCH Dec (M), TC Memo ]. Example: A taxpayer abandoned a residence when the fair market value of the residence was substantially less than the amount of the first and second mortgages encumbering the house. The IRS states that an abandonment is like a voluntary sale (per 1001). The IRS also suggested (but did not rule) that the 121 exclusion provision may be available [PLR ]. Other courts have ruled that abandonment does not create a taxable loss, as there has been no sale or exchange since the taxpayer has not committed to the foreclosure action. Short Sales How Are They Taxed? A new type of transaction created by the tough economic times is called a short pay or a short sale. Typically, the lender agrees to the sale of mortgaged property by the debtor for an amount less than the outstanding recourse debt. Short sales are taxed the same as foreclosures. With a short sale, the lender has three possible ways to handle the deficiency balance, which is the portion of the mortgage debt not covered by the sale of the home. William Roos, EA 13 Foreclosures & Cancellation of Debt

16 First, the lender can attempt to collect the deficiency balance from the seller after the property has closed. While this process is going on, there can be no 1099-C issued as the debt has not been cancelled. The taxpayers should not get a 1099-A in a short sale situation. Second, the lender may require the seller to sign an unsecured promissory note for the deficiency balance as a condition of agreeing to the short sale. If the new note is for less than the balance of the original debt, the difference would be considered canceled, or forgiven, debt. Third, the lender may agree to cancel the entire deficiency balance. For nonrecourse debt short sales where the seller and buyer require the cancellation of the debt by the lender as a condition of the sale, the debt cancellation is included in the sale proceeds, like for a foreclosure. (Briarpark v. Commissioner, 5th Circuit, 99-1 US Tax Cases ,209, 1/6/1999; T.C. Memo , 6/30/1997. Also see Treasury Regulations Section ) Selling Expenses. What about selling expenses for a recourse mortgage? For a short sale, selling expenses reduce the sales proceeds available to reduce the loan. For a foreclosure or deed in lieu of foreclosure, selling expenses are added to the debt. (Jerry Myers Johnson v. Cornnzissioner, TC Memo , affirmed CA4, USTC 50,391.) The net result should be similar, assuming the fair market value of the property equals the selling price for a short sale. For example, for foreclosure of a recourse debt. Recourse mortgage balance $500,000 Selling expenses 50,000 Total debt $550,000 Fair market value 450,000 Cancellation of debt (ordinary income) $100,000 Fair market value $450,000 Tax basis -300,000 Selling expenses -50,000 Gain $100,000 For example, for a recourse debt short sale, Sales price $450,000 Selling expenses -50,000 Tax basis -300,000 Gain $100,000 Recourse mortgage balance $500,000 Pay off using net sale proceeds ($450,000 sales price - $50,000 selling expenses 400,000 Cancellation of debt (ordinary income) $100,000 Relief Provisions Exception to the COD income rule relief provisions. If the cancellation of debt (in whole or in part) occurs (1) in bankruptcy, (2) to an insolvent borrower, or (3) to the taxpayer s personal residence, this normally taxable income might becoke eligible for an exclusion [ 108(a)(1)]. William Roos, EA 14 Foreclosures & Cancellation of Debt

17 Comment: Many financially troubled transactions combine both a sale and cancellation of debt. If the cancellation of a loan is part of the sales price and not a stand-alone cancellation of debt, it may not be excluded by these relief provisions and is therefore taxable! Mortgage Forgiveness Debt Relief Act of 2007 (Hr 3648) Cancellation of Acquisition Indebtedness on Principal Residences Excluded From Gross Income. A taxpayer subject to foreclosure might end up homeless and still face a nasty tax bill from Uncle Sam for cancellation of debt income. To address this looming tax dilemma, Congress retroactively added a new '108 exclusion to cancellation of debt income. Effective for discharges of indebtedness on or after January 1, 2007 and before December 31, 2012, the Mortgage Forgiveness Debt Relief Act of 2007 excludes from a taxpayer=s gross income any discharge (in whole or in part) of qualified principal residence indebtedness (new '108(a)(1)(E)). Qualified principal residence indebtedness. Qualified principal residence indebtedness means acquisition indebtedness up to $2 million ($1 million in the case of a separate return) with respect to the taxpayer's principal residence. Acquisition indebtedness with respect to a principal residence generally means indebtedness which is incurred in the acquisition, construction, or substantial improvement of the principal residence of the individual and is secured by the residence. It also includes refinancing of such indebtedness to the extent the amount of the refinancing does not exceed the amount of the refinanced indebtedness [ 108(h)(2)]. Note: For these purposes the term ''principal residence'' has the same meaning as under '121. It does not include the taxpayer=s vacation home, rental or investment property [ 108(h)(5)]. There is a limiting factor that comes into play when the acquisition debt is refinanced. Debt used to refinance qualified principal residence indebtedness is eligible or the exclusion up to the amount of the old mortgage principal just before the refinancing. Note in the illustration to the right that the exclusion is limited to $182,591 which is the debt just before refinancing. (IR , 2/12/2008; H Rept No , PL , p. 5) When a portion of the mortgage is acquisition indebtedness. If, immediately before the discharge, only a portion of a discharged indebtedness is qualified principal residence indebtedness, the exclusion applies only to so much of the amount discharged as exceeds the portion of the debt which is not qualified principal residence indebtedness. Example. Assume Sharon=s principal residence is secured by an indebtedness of $1 million, of which $800,000 is qualified principal residence indebtedness. If the residence is sold for $700,000 and $300,000 of the debt is discharged, then only $100,000 of the amount discharged may be excluded from Sharon=s gross income under this provision. Warning: Homeowners who refinanced their principal residence mortgage to pay off personal credit card debts, car loans or for other personal uses are not entitled to this new exclusion and will have cancellation of debt income. Basis reduction. The basis of the individual's principal residence is reduced by the amount excluded from income in a mortgage reduction on the taxpayer s principal residence. This means that any gain from an William Roos, EA 15 Foreclosures & Cancellation of Debt

18 eventual sale that cannot be excluded under Sec. 121 will be taxed at capital gains rates thus turning what could have been ordinary income into capital gains. While there is no direct mention of this in the code, this provision only applies if the taxpayer keeps the house which has had the debt reduced. Bankrupt or insolvent taxpayers. The exclusion does not apply to a taxpayer in a Title 11 bankruptcy case; instead the present-law exclusion at '108(a)(1)(A) applies. In the case of an insolvent taxpayer not in bankruptcy, the exclusion under the bill applies unless the taxpayer elects to have the present-law exclusion at '108(a)(1)(B) apply. Discharge of indebtedness in exchange for services rendered. The exclusion does not apply to the discharge of a loan if the discharge is on account of services performed for the lender (for example, an employee of the lender who worked for the lender). Excluding COD in a bankruptcy case. Income from the discharge of debt incurred by a taxpayer in bankruptcy is excluded from income altogether, provided the bankruptcy case is not dismissed prior to debt discharge. However, to the extent available, a certain amount of a borrower s future tax benefits (called tax attributes and discussed later) will be reduced. This exclusion from income is allowed, though, regardless of whether the amount of such income exceeds the borrower s future tax benefits (tax attributes) available for reduction [ 108(a)(1)(A); 108(b)]. What is bankruptcy? Bankruptcy is the status of a person on whose behalf a petition has been filed and proceedings are in progress in a federal bankruptcy court. Tax tip: Income from debt discharge before the filing of a bankruptcy petition does not qualify for this exclusion (and may not be entitled to either the insolvency or qualified farm-indebtedness exclusion). Thus, for tax-planning purposes, it is important for a borrower who will be involved in a bankruptcy to have the debt discharged through the bankruptcy court and not by voluntary action of the taxpayer. Excluding COD when the taxpayer is insolvent. Gross income also does not include COD income when the borrower is insolvent. However, the amount excluded cannot exceed the amount by which the borrower is insolvent. Certain of the borrower s future tax benefits (i.e., tax attributes) must be reduced by the amount of income excluded under this insolvency exception. If the borrower remains insolvent after the discharge, all income from the discharge is permanently excluded regardless of whether the amount of such income exceeds the amount of future tax benefits (i.e., tax attributes) available for reduction [ 108(a)(1)(B); 108(a)(3); 108(b)]. What is insolvency? Being insolvent means the taxpayer s liabilities exceed the fair market value (FMV) of his or her assets determined immediately before the discharge (i.e., FMV assets less liabilities equals a negative number). Nonrecourse debt is included in this calculation only when it is involved in the debt discharge transaction itself. Nonrecourse debt is included as a liability for the purpose of determining insolvency to the extent of the fair market value of the property securing the debt. However, nonrecourse debt in excess of the fair market value is included as a liability only to the extent that it is canceled [ 108(d)(3); Rev. Rul , IRB]. When determining whether a taxpayer is insolvent or the extent of insolvency, the following rules must be considered: Exempt Assets. All assets, including those assets that under state law are exempt from creditors, must be included in determining insolvency [Carlson; Quartemont; Ltr. Ruls and ; FSA ]. William Roos, EA 16 Foreclosures & Cancellation of Debt

19 Observation: Per the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, qualified retirement plan account balances and up to $1 million in IRA balances are now generally protected from an individual's bankruptcy creditors i.e. these balances are exempt assets for bankruptcy law purposes. However, this consumer friendly change does not appear to have any impact on the current IRS position (and the Ninth Circuit's agreement with that position as indicated in Carlson) that exempt assets must be included when calculating insolvency for purposes of the Section 108(a)(3) insolvency exception. Spouse's Separate Property. A spouse's separately-owned assets can be excluded from the determination of the insolvent spouse's net worth, even if the couple files a joint return (Ltr. Rul ). Nonrecourse Debt. When computing insolvency, nonrecourse debt is treated as a liability to the extent of the FMV of the property securing the debt. Nonrecourse debt in excess of the property's FMV is treated as a liability to the extent it is discharged; otherwise, it is ignored (Rev. Rul ). (See Example below) Contingent Liabilities. Before a contingent liability can be included in the insolvency computation, taxpayers must be able to prove "it is more probable than not" that they will be called on to pay the liability (Merken). Thus, loan guarantees and disputed debts may or may not be considered, depending on the facts and circumstances. Measurement Date. IRC Sec. 108(d)(3) says a taxpayer's insolvency is determined immediately before a debt discharge. According to the Tax Court, this means the day before the debt forgiveness income is realized (Merken). Example: Excludable debt discharge income for insolvent taxpayer. All of Max's personal assets and liabilities are from his sole proprietorship business. As of August 1, 2010, business operating debts owed to Last Bank were $500,000, and the FMV of business assets was only $350,000. The bank discharges $200,000 of Max's debts in exchange for his promise to take no money out of the business until it becomes healthy. This debt discharge occurs outside of bankruptcy in a voluntary "workout" between the borrower and lender. Just before the debt discharge, Max was insolvent to the extent of $150,000 ($500,000 of liabilities less $350,000 FMV of assets). Thus, he can exclude $150,000 of the $200,000 discharge from income. However, he must reduce tax attributes by up to $150,000. The remaining $50,000 of debt discharge income must be included in Max's income. After the debt discharge, his assets are still worth $350,000, and his liabilities are only $300,000. Thus, $50,000 is taxable because he has been made solvent by that amount as a result of the debt discharge transaction. The $50,000 is reported on Schedule C. Caution: While this example teaches the concept of insolvency and its effect on COD income, it is not realistic in that Max has no personal assets outside the business. He is more than likely to have some assets and as preparers we need to make certain all assets are listed. Example: Effect of nonrecourse debt on insolvency calculations. In 2008, Sally borrowed $200,000 from Bob to purchase land valued at $200,000. The note bore interest at a fixed market rate payable annually; no principal payments were due until The note was secured by the land and was nonrecourse to Sally. In 2010 (when the outstanding note balance was still $200,000 and the William Roos, EA 17 Foreclosures & Cancellation of Debt

20 FMV of the property had declined to $100,000), Bob agreed to reduce the note's principal balance to $150,000. At that time, Sally had other assets valued at $100,000 and other liabilities (for which she was personally liable) of $90,000. She had not declared bankruptcy. A - Amount of Cancelled Debt $ 50,000 Assets Real estate (market value) 100,000 Other assets 100,000 B Total Assets $ 200,000 Liabilities Nonrecourse financing on the land to the extent of the FMV 100,000 Nonrecourse financing on land in excess of FMV to the extent of amount discharged 50,000 Other recourse financing 90,000 C Total Liabilities $ 240,000 D Amount of insolvency (C-B, not <0) 40,000 E Amount excluded from income (lesser of A or D) 40,000 F Amount included in income (A-D) 10,000 Tax Tips: Insolvent taxpayers must be especially careful when they transfer property in connection with debt relief or discharge. Even though the transfer of property may be compulsory and part of an overall agreement with the lender to have the debt discharged, the transaction is divided into two parts. Depending on the facts and the extent of the taxpayer's insolvency, it may be beneficial to minimize the FMV assigned to the property transferred so more debt is treated as discharged by the lender (and therefore eligible for exclusion under IRC Sec. 108). This option is only available if more than one appraisal has been obtained from qualified appraisers and one of the appraisals gives heavier weight to factors that would minimize the fair market value of the property. Appraisal is not a perfect science and therefore appraisals of the same property by different appraisers may have different results. Note: There is a new IRS form in Publication 4681 to calculate the insolvency of a taxpayer. While it lists lots of potential assets and liabilities, it isn t very clear as to calculating the amount taxable and the amount excludable. A more practicable version can be found at The worksheet is not sent to the IRS but must be kept by the taxpayer. Excluding COD when discharging qualified farm debt. Cancellation of certain farm debt may also be excluded from COD income even if the farmer remains solvent! Debt is qualified farm debt if the taxpayer is directly operating a farm business and at least 50% of the farmer s gross receipts for the three tax years preceding the year of debt cancellation were from the farming business. Again, the penalty is the reduction of certain future tax benefits and the exclusion cannot exceed the tax benefits [ 108(g)(3); 1017(b)(2)]. Reduction of Tax Attributes Reduction of certain future tax benefits (tax attributes. The price (or curse) for excluding COD from current gross taxable income under any of the above three exclusions is that the borrower loses certain future tax benefits, such as net operating loss carryover and future depreciation deductions [ 108(b)]. However, prior to decreasing these future tax benefits, the borrower may elect to reduce the basis of his or her depreciable property. This reduction is done at the beginning of the tax year following the tax year of the debt discharge. Election to reduce basis of depreciable property. The borrower may elect (on Form 982, which must be attached to the taxpayer s timely filed income tax return relating to the year of the discharge) to apply any of the COD income first to reducing the basis of depreciable property (but not below zero) before reducing any William Roos, EA 18 Foreclosures & Cancellation of Debt