Tax Prophet: FAQ May 12, 1996

Frequently Asked Tax Questions -- May 12, 1996

This column, in slightly different format, originally appeared in The San Francisco Examiner Newspaper, Sunday May 12, 1996

Tax Consequences of Foreclosure


Note: This exercise is for educational purposes only and is not intended to be legal or tax advice. Your particular facts and circumstances must be considered when applying the U.S. tax law. You should always consult with a competent tax professional with respect to your particular situation.

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  1. Question: My home, for which I paid $100,000, is currently worth $150,000. However, I have accumulated loans against it of $200,000. Am I responsible for taxes if the bank forecloses (sells my house to pay off its loan)? [Answer]
  2. Question: I currently owe $200,000 on my mortgage. Because I have experienced difficulty paying my mortgage, the lender has offered to reduce my debt to $150,000. What are my tax consequences? [Answer]
  3. Question: Can I file bankruptcy to avoid these taxes? [Answer]

  1. Answer to Question #1:

    Yes, a foreclosure would be considered a sale of your residence for $200,000, the amount of the loans, despite a lower market value of $150,000. Because you own your home are living in it, California's anti-deficiency statute prevents the lender from collecting additional sums from you once the foreclosure sales occurs. Consequently, your loan is considered "non-recourse." A non-recourse loan foreclosure is taxed as a sale of property for the full loan amount ($200,000), rather than the current value of your property ($150,000). Therefore, you will have income (generally taxed as a capital gain) of $100,000, even though the sales proceeds went to your lender. Technically, you will owe this tax even if you are insolvent or declare bankruptcy shortly after the foreclosure.

    If your property was located in a state that permitted the bank to recover from you the remaining balance owed after the foreclosure sale, the debt would be "recourse" and different rules would apply. A recourse loan foreclosure is taxed as a sale of the property for its value ($150,000) and the balance ($50,000) of the loan is treated as income from the cancellation of debt ("COD"). COD income may be excluded under certain conditions (described in the next question).


  2. Answer to Question #2:

    Any debt reduction by a third party lender is taxed as COD income since you initially received the money in the form of a loan. A debt reduction by the seller of property ("purchase money debt") is treated as a decrease in the purchase price and is not regarded as COD income, although the property's tax basis (your tax basis is generally the purchase price, plus improvements, less depreciation) is then lowered by the amount of the decline. This can have consequences on your depreciation deduction and will cause an additional gain on the property when it is sold.

    If you are insolvent or have filed for bankruptcy, COD income is actually only a gain on paper and is excludable from your gross income. In other words, forgiveness of debt when a taxpayer is insolvent does not create income. You are insolvent if, immediately prior to the debt reduction, your liabilities exceed the current value of your assets.

    If you are solvent, but not in bankruptcy, the amount of the debt discharged is excluded from gross income to the amount by which you are rendered insolvent: If a creditor reduces his debt by $50 and you have $20 in the bank, you are partially solvent with $20 in COD income. The remaining $30 of COD income would be excluded from your gross income under the insolvency exception.

    In both insolvency and bankruptcy cases, the amount excluded reduces other tax benefits, such as your tax basis, in other properties. For example: While you are insolvent, a lender relieves you of $50,000 in debt on Property A. You also own property B with a tax basis of $75,000 and a value of $70,000. The tax basis on property B is reduced from $75,000 to $25,000, to account for the $50,000 of COD income excluded under the insolvency exception. A later sale of that property would produce a gain of $45,000 (absent this adjustment, there would have been a loss of $5,000 on the sale).

    A "short sale" (the bank lowers its debt to the property's current market value, then the taxpayer sells the property to another person) will produce COD income with respect to the debt reduction. This COD income may be excluded, provided the taxpayer meets the insolvency exception provisions.


  3. Answer to Question #3:

    By filing bankruptcy, you can eliminate your liability for income taxes that are more than 3 years old, provided you have filed a non-fraudulent tax return at least two years before declaring bankruptcy. If the IRS has assessed you additional taxes, you must wait 240 days from the date of assessment before filing for bankruptcy.

    For example, if you incurred a $100,000 capital gain in 1996, the due date for that return will be April 15, 1997. If you file a non-fraudulent tax return by the due date, you must wait until April 16, 2000, to eliminate your tax liability in bankruptcy.



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**NOTE: The information contained at this site is for educational purposes only and is not intended for any particular person or circumstance. A competent tax professional should always be consulted before utilizing any of the information contained at this site.**