Article of the Week
“TAXATION OF SHORT SALES AND FORECLOSURES”
by Mark Ericsson
In the following schedules, I will present the tax consequences of a divestiture of property through a short sale (in which the lender agrees to take less than the loan balance), foreclosure, or deed in lieu of foreclosure in four different settings. In each case, the property is "underwater."
The first schedule (click on the images above or scroll down) describes the situation in which the homeowners have held the principal residence for a long time and their cost (basis) is currently far less than their loan balance. In the second schedule, the house was bought at the top of the market and the homeowners' cost exceeds the home's worth as well as the current loan balance. The third and fourth schedules retrace the first and second in the case of investment properties.
The focus of any inquiry into the tax consequences of short sales and foreclosures is how much gain and how much cancellation of indebtedness is recognized in the transaction. Gain is the amount one realizes over the amount that one has invested, or how much the value increased. Income is realized to the extent that one's net worth increases, unless the income can be excluded by statute or case law. In the case of cancellation of indebtedness income, if the bank agrees to compromise a $20,000 debt to $10,000, one's net worth has increased by $10,000 which is considered to be income. As one studies the four schedules, two factors come into play. First, gain is taxed federally at a maximum rate of 15% (20% next year) while cancellation of indebtedness income is taxed at a maximum rate of 35% (39.6% next year). Therefore, any comparison must start with how much tax is generated at the two different rates.
Secondly, both gain and ordinary income can be excluded. There is one exclusion for gain on principal residences and there are five exclusions for cancellation of indebtedness income. Therefore, one must determine if one of the exclusions applies and if there is any detriment caused by applying the exclusion.
The applicable exclusion for gain is the $250,000/ $500,000 section 121 exclusion for homeowners who have owned and occupied the home for two out of the last five year prior to sale. There are five ways to exclude income from cancellation of indebtedness income which are found in IRC §108. They are the insolvency exclusion (taxpayer may exclude an amount of COD Income equal to the excess of the COD Income over the net worth of the taxpayer immediately after the sale), the bankruptcy exclusion (where personal liability has been eliminated by a bankruptcy before or within the bankruptcy), the election to exclude acquisition indebtedness under IRC §108(a)(1)(E), and two that rarely apply to personal residences or rentals (farms and property used in a trade or business).
If either of the first two exclusions under §108(a)(1) are relied upon, the taxpayer's tax attributes must be reduced by the amount excluded, effective the first day on the year following the exclusion. Tax attributes are the results of events that allow the taxpayer future tax reduction such as the net operating loss carry forward. For example, if the taxpayer has a $100,000 net operating loss and excludes $50,000 of cancellation of indebtedness income in a bankruptcy, he or she can only carry forward $50,000 of the net operating loss. The reduction of the taxpayer's attributes include these attributes in the following order: net operating loss carryovers, business credit carry forwards, minimum tax credit carry forward, capital loss carry forwards, the taxpayer's basis in his or her assets, passive loss carry forwards and foreign tax credit carry forwards. Since the attributes are reduced on the first day of the year following the exclusion, it is generally advantageous for the taxpayer to realize any such gains in the year of exclusion.
There is an open question on the IRC §108(a)(1)(E) election. IRC 108(h)(1) states that the taxpayer must lower the basis in his or her principal residence by the amount excluded. The attached schedules assume that this means that the basis of the home foreclosed or sold must be reduced, but there is no guidance as to whether this reduction of basis should be retroactively applied to a home that the taxpayer no longer owns. California has passed a similar statute, but with an $800,000 limitation on the amount of acquisition debt applicable rather than the $2,000,000 allowable under federal law.
In the first schedule (Principal Residence – Low Basis), the loan balance is $1,000,000, the fair market value of the property is $600,000, and the owners paid $300,000 for the property. There are two columns, one illustrating the tax consequences of a short sale and the other illustrating the tax consequences of a foreclosure. The tax consequences of tendering a deed in lieu of foreclosure are the same as those of a short sale with the fair market value substituting for the sale price.
Following the first column, we first look at the ramifications of a short sale. In a short sale, where the bank forgives the balance of the loan, the sale is traditionally treated as a sale and cancellation of the balance of the loan. There will be $400,000 in cancellation of indebtedness income (the difference between the loan balance and the sales price). This may be excludable under one of the five exclusions referenced above. There will also be $300,000 in gain which will be excludable if the owners are a couple who have lived in the house two out of the last five years.
Following the second column (Foreclosure), it will not make a difference whether the loan is recourse or non-recourse, but whether the foreclosure was judicial or non-judicial. The Internal Revenue analysis of the tax consequences generally begins with a determination of whether the loan is a recourse or non-recourse loan. If the loan is non-recourse, the property is treated as sold for the outstanding loan balance. If the loan is recourse, the property is treated as sold for its fair market value (the price at which it sells at the foreclosure sale) and the balance of the recourse loan is treated as cancelled debt (the same treatment as a short sale or deed in lieu of foreclosure transaction). However, one might ask in the case of a non-judicial foreclosure, during which the bank essentially converts a recourse loan to a non-recourse loan, whether the loan should be treated as recourse or nonrecourse? The bank will invariably report it that the debtor was "personally liable" on the Form 1099-A. IRC §7434 provides a remedy for misreporting by a bank which is a fairly common occurrence.
66 AFTR 2d 90-5901 (6th Cir. 1980) found that, in the case of a non-judicial foreclosure, it made no difference whether the loan is recourse or non-recourse. The Court pointed out that under IRC §1001, gain is determined by the excess of cash and property received over the basis in the property. Essentially, the debtor is exchanging the deed to the property for the canceled note. Therefore, the value of the canceled note is property received by the taxpayer and the result is the same as the treatment of a non-recourse loan. See also Robert C. Wicker, 1993 RIA TC Memo ¶93-431. The inquiry is focused on whether the cancellation of personal liability was part of the sale. One might wonder if this is true in a short sale, although the short sale can be distinguished in that the buyer in a short sale is not the lender cancelling the debt. Keep in mind that the issue remains open in the Ninth Circuit Court of Appeals and that the Internal Revenue could pursue the "recourse, non-recourse" line of reasoning.
Under the Chilingirian reasoning in the non-judicial foreclosure, which I would argue any day, the property is deemed to be sold at the loan balance and no cancellation of indebtedness income is generated. The taxpayers' gain is $700,000 of which $500,000can be excluded by a couple. The schedule follows the Chilingirian reasoning. If the Chilingirian reasoning is followed, the return should include an explanation since the 1099-A will suggest a different treatment. This is one of those delicious conundrums in which you could report the transaction consistent with IRS thinking and are not likely to be questioned.
In the case of a non-judicial foreclosure, the gain will be $300,000 which is excludable gain, and the deficiency will become cancellation of indebtedness income if it is forgiven. Often, particularly in the case of a second loan which remains an unsecured liability following the foreclosure, personal liability will be discharged in a bankruptcy following the foreclosure or short sale, and the cancellation of indebtedness income will be excluded.
Going back to the non-recourse loan in the short sale column, the reasoning of Chilingirian would certainly suggest that if the debt is forgiven as part of the short sale, the result should be the same as in the foreclosure case (no cancellation of indebtedness income and $700,000 in gain). Here again, one may have one's choice of outcomes with relative impunity.
In analyzing the case of a low basis residence, a short sale might make sense if the COD income can be excluded. If a second loan was used to procure the residence, it is treated asacquisition indebtedness. Since the second becomes an unsecured promissory note when a first forecloses, a short sale may allow the homeowner to negotiation a resolution of the second. A deed in lieu of foreclosure produces the same results as a short sale and might be advantageous because there may be more room for negotiation on the fair market value and the credit implications are slightly less severe. However, in most cases, the non judicial foreclosure route provides the preferable tax result.
The results shift when analyzing commercial or rental property. This is in part because while a loss on a personal rental is not deductable, a loss in the case of an income producing property is deductable under IRC §1231 against ordinary income. Therefore, a short sale or deed in lieu transaction can lock in an ordinary loss if the COD income is excludable and produce a desirable result.
Mark Ericsson practices tax, business and estate planning with the Walnut Creek firm of Youngman, Ericsson & Low, LLP. Mark has served as President of the Bar Association and has chaired numerous committees including the joint IRS-Practitioner Liaison committee, state Tax Litigation and Procedure committee, and county tax section. Mark has written over fifty articles on taxation and speaks frequently on tax issues.