Taxation of Canceled Debt

A debt that is canceled by the lender because it cannot collect the debt, such as in a foreclosure or a short sale, or because the statute of limitations prevents the collection of the debt is considered to be taxable ordinary income – otherwise known as cancellation of debt, or COD, income unless:

• the debt was discharged in bankruptcy;
• the debtor is insolvent, with debts greater than assets;
• the fair market value (FMV) of the home is greater than the canceled debt, since, then, the debt would be paid by the sale;
• or the canceled debt was a gift from a friend or relative. There is an irrebuttable presumption that debt canceled by a commercial lender is not a gift.

COD Income = Canceled Debt Amount - FMV

There may also be a tax on capital gains on the forced sale of property securing a debt.

Although it may seem harsh to tax canceled debt when the borrower is down on his luck, these rules are necessary to prevent abuses, where, for instance, phony loans may be used as a payment for services by solvent borrowers.

Foreclosures and Short Sales

Whenever a canceled debt involves real estate, the amount of COD and taxable income will depend on several factors:

• whether the debt was a recourse or nonrecourse loan,
• the fair market value of the real estate,
• the borrower's tax basis in the property,
• the sale price of the property,
• whether there were unpaid property liabilities, such as real estate taxes.

When a lender forecloses on a home, or if the home is sold in a short sale, the IRS treats it as a sale. For a nonrecourse loan, where the borrower is not personally liable for any deficiencies, where the sale proceeds does not cover the full amount of the debt, then:

Sales Price = Canceled Debt of Nonrecourse Loan

Any deficiency of a nonrecourse loan is not considered to be COD income because the borrower has no liability for it, so there is no legal effect of having it forgiven. Although there is no COD income for a nonrecourse loan, there may be capital gains on the property if the borrower's tax basis is less than the sales price.

Capital Gain Income = Canceled Debt of Nonrecourse Loan - Borrower's Tax Basis

If the borrower is personally liable for the debt, then the sale price is equal to the canceled debt up to the fair market value of the home.

Sales Price = FMV - Canceled Debt of Recourse Loan

If the canceled debt is greater than the FMV, then the difference is ordinary income:

Ordinary Income = Canceled Debt + Unpaid Property Liabilities - FMV - Paid Property Liabilities

Unpaid property liabilities for the year in which the sale or foreclosure takes place, such as property taxes, are added to the canceled debt since the lender will be liable for those costs, unless the borrower ultimately pays them. The lender is required to send a Form 1099-C, Cancellation of Debt (COD) to the borrower, listing the amount of ordinary income. 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 recourse loan, there may be both ordinary income and capital gains taxes to be paid. Income taxes must be paid on the difference between the COD income and the fair market value of the property. If the fair market value is greater than the adjusted basis of the property, then there will also be a taxable capital gain.

Ordinary Income = COD on Recourse Loan - FMV

Capital Gain = FMV - Adjusted Basis of Property

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.

Capital Gain = Canceled Debt of Nonrecourse Loan - Adjusted Basis of Property

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.

However, if the home was the borrower's main residence, then there may be no capital gains tax due since the IRS exempts gains of $250,000 for a single taxpayer or $500,000 for a married couple filing jointly on a main residence where the taxpayer lived for at least 2 years out of the 5 years before the sale. ^{IRC §121}

If any due 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 COD income tax would be due. Although a higher FMV may increase the capital gain on the home, the long-term capital gain tax is usually much less than the tax on ordinary income.

Tax Publications and Forms Concerning Canceled Debt

• Publication 523, Selling Your Home
• Publication 537, Installment Sales
• Publication 544, Sales and Other Dispositions of Assets
• Publication 908, Bankruptcy Tax Guide
• Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness
• Form 1040, U.S. Individual Income Tax Return
• Form 1040, Schedule D, Capital Gains and Losses
• Form 1099-A, Acquisition or Abandonment of Secured Property
• Form 1099-C, Cancellation of Debt
• Form 4797, Sales of business Property

Tax Updates

Tax Debt Relief by the IRS

Because of the recent credit crisis and the large number of taxpayers that became deeply indebted, the IRS has instituted the following rules to mitigate their problems:

• The number of liens filed by the IRS has increased from 168,000 in 1999 to 1.1 million in 2010, so the IRS is implementing the following changes concerning tax liens:
  • The IRS will not file a property lien if the amount owed is less than $10,000, which is double the previous amount.
  • When the debt is paid, then the IRS will grant the taxpayer a lien withdrawal, where the IRS will not only release the lien, but will also remove it from the credit reports of the taxpayer. Usually, a lien release stays on the credit report for 7 years, which can cause the credit score of the taxpayer to drop by up to 100 points for someone with an initially high score. The IRS may grant a lien withdrawal even if the taxpayer has not fully paid off the debt, if the amount is less than $25,000 and the taxpayer agreed to a direct debit from his bank account.
• For small businesses, the IRS will also offer streamlined installment agreements, allowing a business to pay off a tax debt of $25,000 or less over a period of 24 months if the taxpayer agrees to an automatic debit from his bank account. Previously, the IRS only allowed this if the debt was $10,000 or less.
• The IRS may also offer the taxpayer an offer in compromise, allowing the taxpayer to pay a lot less than what is owed, if the IRS is convinced that the taxpayer will be unable to pay the full amount of the debt, and the amount owed is less than $50,000 and the taxpayers income is less than $100,000, which is double the previous limits.

Taxes on Cancellation of Debt (COD) in Foreclosure

When a lender forecloses on a home, 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.

However, the tax is not owed:

• if the debt is discharged in bankruptcy;
• the debtor is insolvent, with debts greater than assets;
• the fair market value of the home is greater than the canceled debt;
• or the loan was from a friend or relative and the canceled debt is treated as a gift. Any debt canceled by a commercial lender is not considered a gift by the IRS.

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.

After Foreclosure, a Big Tax Bill From the I.R.S.