The Unanticipated Tax Consequences in a Short Sale or Foreclosure
Taxation Committee
Real Estate Finance Committee
Legislative CommitteeThe following is for study only and has NOT been
approved by theTaxation Committee, Real Estate Finance Committee,
Legislative or Executive Committees or the Board of Directors.
Issue
Should homeowners who are already losing their home due to a short sale or
foreclosure be relieved of also having to pay income tax on the forgiveness
of the outstanding debt?
Action OptionalOptions
1. Sponsor legislation that would characterize refinanced debt as
non-recourse as opposed to recourse debt which would, thus, preclude a
taxpayer from having to potentiallypay income tax on debt forgiveness
income that may occur in the event of a short sale or foreclosure.
2. Support legislation described in Option 1.
3. Sponsor legislation that would require lenders to provide a disclosure to homeowners that are refinancing,taking out a second mortgage or getting a home equity line of credit informing them of the tax consequences that may potentially occur in the event of a short sale or foreclosure.
4. Support legislation described in Option 3.
5. Other.
6 Do nothing.Status/Summary
In a short sale or foreclosure, the homeowner not only loses their home but
may also end up being taxed on income they never received. In both
instances, the lender ends up getting less than the full amount of the
outstanding balance and, consequently, the amount the borrower is no longer
responsible for paying to the lender is considered cancellation of debt
(COD) income and, thus, income to the borrower and subject to income
tax. This scenario cannot happen if the outstanding mortgage debt is
from the original mortgage because under state law the borrower can "walk
away" from the mortgage with no personal liability. However, if the
homeowner refinanced their mortgage, the nature of the debt was changed and
the homeowner ispersonally liable for payment of the debt.
Conceivably, since the borrower is already losing their home they should
not also have to pay income tax. At a minimum, should consideration
be given to requiring a disclosure from lenders to homeowners who are
refinancing, taking out a second mortgage or a home equity line of credit
as to the potential tax implications that may occur in the event of a short
sale or foreclosure?Discussion
The recent rash of foreclosures has highlighted a "doublewhammy" that can
occur in a short sale or foreclosure action: the former homeowner not only
loses their home but is also taxed on income they never received.
State Senator Lou Correa has already announced that he plans to introduce
legislation to address this issue at the state level and plans are also
afoot for action at the federal level. (Note: See the federal issues
summary of the Taxation Committee's Agenda Summary for more information
regarding the federal level action.)How can this problem arise?
Suppose that a homeowner lost their job, became seriously ill or lost their
spouse such that they were unable to continue to make their home mortgage
payments. Two things can occur at this point. The homeowner can
negotiate a"short sale" with their lender in which the lender agrees to let
the borrower sell the house for less than the outstanding amount of the
mortgage and turn the proceeds from the sale over to the lender as payment
in full. Or, the homeowner fails to make the regular mortgage
payments and the lender forecloses on the home which results in the lender
selling the home to satisfy all or a portion of the outstanding mortgage
loan balance. Note that a "down" housing market has the effect of
increasingthe difference between the amount for which the home is sold and
the amount of the outstanding mortgage loan balance due to the home
commanding a lower sale price. Consequently, the lender ends up
receiving less than the full amount of the outstanding balance.In both
instances, the amount the borrower is no longer responsible for paying to
the lender is considered cancellation of debt (COD) income and, thus,
income to the borrower subject to income tax. How can this be
considered income giventhat it appears that the borrower never received any
money? In fact, when the borrower took out a mortgage to purchase
their home, the lender gave the borrower money which used to pay the
previous owner of the home. However, because there wasan offsetting
obligation - the mortgage debt - the borrower/new homeowner wasn't
taxed. If any portion of that offsetting obligation is eliminated -
like in a short sale or foreclosure - it is considered income. This
income is not consideredany different than what is normally considered
income. And, in fact, can result in a "third whammy" in that the
additional COD income can push the borrower into a higher tax bracket so
that not only do they have to pay taxes on the COD income but have to pay
taxes on all their income - including the COD income - at a higher tax
rate!There are three instances in which income tax will not have to be paid
on COD income. Two are bankruptcy and insolvency. So, arguably, an
individual that was lessresponsible than someone who arranged a short sale
with their lender or who tried to make their mortgage payments but
ultimately failed is in a better position vis-à-vis their income
taxes. Needless to say, however, bankruptcy and insolvency have their
own financial downsides.The third instance is if the mortgage is
"non-recourse" debt. Under state law, there is no personal liability
for a purchase money mortgage for a personal residence (which can include
an owner occupied residence of up to 4 units) or the financing carried back
by the seller. The borrower can simply walk away from the debt and
the lender has no recourse for recovering the amount of the outstanding
mortgage balance from the borrower. However, if the debt does not
meet either of these two exceptions, the mortgage is considered "recourse"
debt and any COD income is subject to income tax.More importantly, there
are a number of ways in which the characterization of debt secured by a
home can change from non-recourse to recourse debt - ways that the borrower
may not realize are changing the nature of the debt and, thus, the tax
consequences. Chief among these is if the home was refinanced - which
countless numbers of homeowners have done over the past few years when
interest rates were declining; any amount refinanced is recourse debt and,
thus, subject to income tax. (The same is also true of second
mortgages and home equity lines of credit).So, what could be done to help
homeowners who through no fault of their own, in addition to not only
losing their home, also have to pay income tax on COD income - which
increases in a "down" housing market which is also not the fault of the
homeowner - as the result of a short sale or foreclosure? The simple
answer is to allow the debt to retain the original characterization as
non-recourse debt.However, homeowners often refinance for a new debt amount
that is greater than the outstanding balance of the original
mortgage. They do so for a variety ofreasons, ranging from wanting to
remodel their home to taking a vacation to Tahiti. Thus, the question
arises as to whether the retention of the characterization as non-recourse
debt suggested above should apply to (1) all debt refinanced, (2) the
remaining portion of the original mortgage and any additional debt used for
home improvements, or (3) only the outstanding balance of the original
mortgage.Finally, if the nature of refinanced debt is to continue as
recourse debt, consideration should be given to requiring a disclosure from
lenders to homeowners who are refinancing, taking out a second mortgage or
a home equity line of credit as to the potential tax implications that may
occur in the event of a short sale or foreclosure.
