Forced Home Sale Can Result in Income to the Borrower

When the real estate market was booming, homeowners either borrowed heavily to buy in at the top or took out home-equity loans, which added to their debt. Now that the real estate market has cooled, some homeowners are waking up to an unpleasant reality: They can’t make their mortgage payments, and their debt exceeds the property’s fair market value. Often a foreclosure, which may be only a missed mortgage payment or two away, is the inevitable conclusion to an otherwise uncertain situation. But the homeowners not only owe money to the bank, they can also face some unexpected income tax consequences if the unpaid amount of the loan is forgiven by the lender.

Typically, lenders do not want to own real estate. They will go to great lengths not to foreclose. It is a lengthy and costly process. They are in the business of lending money, not owning real estate. A foreclosure puts a nonperforming asset on the lenders’ books.

DEBT DISCHARGE INCOME
A foreclosure (or deed in lieu of foreclosure) can result in income to the borrower if the lender forgives some or all of the unpaid debt. In general, cancellation or forgiveness of a debt results in gross income—debt discharge income—for the borrower, unless an exception applies because the taxpayer declared bankruptcy or was insolvent at the time of discharge. Borrowers must report this income on their tax returns (on the “Other Income” line of Form 1040 or on Schedule C), and certain lenders (for example, banks and other financial institutions) must issue a Form 1099-A, Acquisition or Abandonment of Secured Property, to the borrower, reporting the balance of the loan and the fair market value of the property.

FORECLOSURE BY LENDER
When a property is foreclosed on, the taking of the property by the lender in satisfaction of the recourse debt is treated as a deemed sale, with proceeds equal to the lesser of the property’s fair market value at the time of foreclosure or the amount of secured debt. If the amount of debt exceeds the property’s fair market value, the difference is treated as debt discharge income if it is forgiven. The bid price in a foreclosure sale is presumed to be the property’s fair market value, unless there is clear and convincing proof to the contrary.

Debt discharge income occurs in a foreclosure transaction only if the lender discharges part or all of the debt upon taking the property securing it. If the lender fails to pursue the debtor or to discharge the balance, debt discharge income results when the status (under state law) for enforcing the debt expires.

For a detailed discussion of the issues in this area, see Tax Clinic, “Short Sale or Foreclosure of a Principal Residence,” by Steve R. Picha, CPA, and Yadira E. Hiraldo, CPA, in the September 2007 issue of The Tax Adviser.

—Alistair M. Nevius, editor-in-chief
The Tax Adviser