Taxation of Canceled Debt

When a debt is canceled by the lender because it cannot collect the debt, such as in a foreclosure or a short sale, the IRS considers the canceled debt as taxable ordinary income.

Foreclosures and Short Sales

When a lender forecloses on a home, or if the home is sold in a short sale, the IRS treats it as a sale. If the borrower is not personally liable for the debt, such as would be the case for a nonrecourse loan, then the selling price is equal to the price of the cancelled debt. If the borrower is liable for the debt, then the sale price is equal to the canceled debt up to the fair market value (FMV) of the home. If the canceled debt is greater than the FMV, then the difference between the debt and the FMV is treated as ordinary income, for which the lender is required to send a Form 1099-C, Cancellation of Debt (COD), listing the amount of ordinary income. Any unpaid liabilities on the property, such as property taxes, will reduce the FMV of the home and increase the COD. However, if the liabilities are paid by the borrower, then this will increase the FMV and decrease the COD. The lender will also send a Form 1099-A, Acquisition or Abandonment of Secured Property, that will allow the borrower to determine the capital gain or loss from the foreclosure. Taxes must be paid on the capital gain in addition to any ordinary income from the canceled debt that exceeds the FMV of the home in a recourse loan. For a nonrecourse loan, any income is treated as a capital gain equal to the canceled debt minus the adjusted basis of the property—there is no COD income. However, a capital loss from a foreclosure cannot be deducted.

With the recent decline of home prices, many homes are worth less than the amount of money owed on the property, especially for borrowers who took advantage of lax lending standards, and bought with no money down or used inflated home appraisals. Consequently, many homeowners whose homes were foreclosed by the lender may owe a significant amount of taxes.The IRS treats all forgiven debt as ordinary income, even though in the case of foreclosure, the homeowner doesn’t get to keep the home.

If the taxes are not paid for the year the debt was canceled, then the IRS adds penalties and interest to the total tax bill, which can often be tens of thousands of dollars.

Because the lender has some discretion in valuing a home, it can sometimes be successfully argued that the fair market value of the home was greater than the debt, in which case, no tax on COD is due.

Questions and Answers

Why is it that I may have both gain (or loss) and cancellation of Debt (COD) income upon foreclosure of my house?

In many home foreclosures, the mortgage debt is recourse and the fair market value (FMV) of the house is less than the unpaid face amount of the debt. Often in this situation the borrower/debtor transfers the house to the lender or to a 3^rd party, either through a deed in lieu of foreclosure or as a result of a foreclosure proceeding. This transfer is treated as a sale or other disposition of the property and results in the borrower/transferor realizing gain or loss. At the time of the transfer, the lender often cancels the remaining mortgage debt, leading to COD income.

What is COD income, and how is it calculated?

Loan proceeds are not included in income when received because there is an offsetting obligation to repay. However, if the debt is cancelled in part or full in a foreclosure proceeding, you will have COD income equaling the difference between the unpaid amount of the debt and the FMV of the property you transfer to the lender or a third party to discharge that debt. For example, if your debt prior to foreclosure was $200,000 and the FMV of the property was $170,000, you would have $30,000 of COD income.

Note: If you borrow money from a friend or relative and he or she cancels all or part of the debt, the cancellation often is treated as a gift from the lender to you. Gifts, including gifts of cancelled debts, are excludible from income. However, the cancellation of debt by a commercial lender is not a gift.

Can the amount of COD income be affected by other liabilities relating to the property?

The existence of other liabilities, such as property taxes, can either increase or reduce the amount of your COD income. For example, there may be unpaid property taxes that are treated as imposed on you for federal tax purposes. If you have not provided funds to pay the property taxes, the taxes generally either remain as unpaid charges against the property after foreclosure or must be satisfied from the sales proceeds from the foreclosed property prior to any application of such proceeds to satisfaction of the debt. The unpaid liabilities reduce the amount of the FMV of the property that is available for satisfaction of the debt and must be taken into account in computing the amount of COD income.

For example, suppose your debt prior to foreclosure was $200,000 and the FMV of the property was $170,000, but you had $10,000 of unpaid property taxes. In this situation, because the FMV of the property available to satisfy the debt would be only $160,000 ($170,000 FMV less $10,000 unpaid taxes), the COD income would be $40,000 ($200,000 debt less $160,000 FMV).

On the other hand, if you pay property taxes that for federal income tax purposes are treated as imposed on the owner of the property, this may reduce the amount of your cancelled debt income. Thus, if you paid $10,000 of property taxes that for federal income tax purposes are imposed on the owner of the property after the foreclosure, your FMV would be $180,000 ($170,000 plus $10,000) and your COD income would be $20,000 ($200,000 debt less $180,000 FMV).

How do I compute gain or loss on a disposition by foreclosure?

Gain or loss is the difference between your amount realized and your adjusted basis in the property. In general, an amount realized by the transferor on a foreclosure or other transfer of property is the sum of: (1) the amount of money received; (2) the FMV of any other property received; and (3) the amount of any other liabilities that the transferee (the person acquiring the property) either assumes or takes the property subject to.

Example — recourse debt in which both gain and COD income results from the foreclosure.

If the face amount of the recourse debt is $200,000, the FMV of the property is $170,000, and the adjusted basis is $120,000, you have $30,000 of COD income ($200,000 debt less $170,000 FMV) and $50,000 of gain ($170,000 FMV (amount realized) less $120,000 adjusted basis).

If the mortgage debt is nonrecourse, is there COD income on the foreclosure?

If your mortgage debt is nonrecourse, the debt is greater than the FMV of the house, and the house is foreclosed upon, your amount realized will be the face amount of the unpaid mortgage debt. Thus, if the amount of the nonrecourse debt is $200,000, the FMV of the property is $170,000, and the adjusted basis of the property is $120,000, your gain on foreclosure is $80,000 ($200,000 amount realized less $120,000 adjusted basis). No portion of the gain on property subject only to nonrecourse debt is COD income.

If your house is foreclosed upon and your mortgage debt is recourse, are there circumstances in which you may have gain or loss but not COD income?

There are at least 2 situations involving recourse debt in which foreclosure results in gain or loss, but not in COD income.

First, sometimes when a house is transferred to the lender by foreclosure the lender does not cancel the remaining unpaid portion of the debt. This could happen if the lender believes it can still collect the balance of the debt. In that circumstance, you would not have COD income until the lender discharged the debt or the statute of limitations on collection of the debt expired. The gain or loss on the foreclosure is the difference between the FMV of the property and its adjusted basis.

Second, sometimes the FMV of a house that is foreclosed upon is greater than the amount of the debt. If the FMV is sufficient to pay the debt in full, the debt is satisfied and there is no COD income because no part of the debt was discharged or cancelled. For example, if the FMV of the house was $200,000, the amount of the debt was $140,000, and the adjusted basis of the house was $110,000, the gain on the sale of the house is $90,000 ($200,000 FMV (amount realized) less $110,000 adjusted basis), but there is no COD income because the FMV of the house is $60,000 ($200,000 FMV less $140,000 debt), which is more than enough to satisfy the debt in full.

Can COD income ever be excluded from my gross income?

You may be able to exclude all or part of the cancelled debt income if all or part of the debt was discharged in bankruptcy, if you were insolvent immediately before the transfer, or if the debt is a qualified farm debt or qualified real property indebtedness. Refer to Publication 908 (PDF),Bankruptcy Tax Guide.

How do I report COD income on my return?

If the house is your principal residence, you may be able to exclude part of all of the gain under I.R.C. 121. See Publication 523, Selling Your Home.

How do I report a foreclosure gain or loss on my return?

Gain or loss on the foreclosure of your house usually is a capital gain or loss. However, a loss on the foreclosure of your residence is not deductible. Capital gains are reported on Form 1040, Schedule D (PDF). If, however, the gain on the foreclosure of your residence is excluded under I.R.C. 121, you are not required to report the gain on your return.

Information is provided 'as is' and solely for education, not for trading purposes or professional advice.