| 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
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