As Foreclosures Soar, Congress Steps in to Prevent a Painful Double Whammy

At first blush, the rule seems so unfair that it must be a cruel hoax. First, you lose your house in a foreclosure—perhaps you fell behind in the payments after you lost your job, you got sick, or your husband or wife died. Then the law orders the IRS to pile on the emotional and financial grief by charging you extra income tax.

Outlandish, perhaps. But, until just before Christmas, that was the law. First, a look at the basic rule, then a review of the temporary fix that will benefit tens of thousands of taxpayers… starting with 2007 tax returns filed this Spring.

Under the law, if the bank forecloses and sells your home for less than the amount left on your mortgage—and forgives the excess debt—the amount forgiven is treated as taxable income to you. That’s right; as far as the income tax is concerned, money you don’t have to pay back is treated the same way as money paid to you: Taxable in your top bracket. The IRS even has a special form for reporting this “windfall”: the 1099-C. The C stands for cancellation of debt and the law says cancelled debt is taxable as income. (There are exceptions, which we’ll get into later.)

As a wave of foreclosures began sweeping across the nation in 2007—fueled by the risky loans, rising rates, and a slowing housing market—this arcane rule began to get more and more attention. So did other efforts by strapped homeowners—such as “short sales” or loan restructuring—that can also trigger 1099-Cs reporting taxable income. If a lender agrees to freeze an adjustable interest rate for a period of time rather than allow it to rise as called for in the mortgage, for example, the change can result in forgiven debt that would be taxable under the regular rules.

Congress steps in with relief

To protect homeowners from this double whammy, Congress declared that when a taxpayer’s principal residence is involved, forgiven debt will not be treated as income. This break applies only for 2007, 2008, and 2009. After that, the old rule comes back into play. This is a big deal for affected taxpayers. Congress estimates the three-year suspension of the rule will save people who lose their homes—or stay in them thanks to a loan restructuring—about $600 million.

There are limits, of course, and it is important to know what’s covered and what’s not.

• This relief applies only to principal residences, that is, the home you live in. If a lender forgives debt after a foreclosure, short sale or loan restructuring for a vacation home or investment property, for example, the old rule still applies: The amount of debt canceled is considered taxable income to you (unless you qualify for one of the exceptions discussed later). Congress didn’t want to offer a helping hand to speculators who helped fuel the housing boom by buying properties in hopes of “flipping” them quickly for hefty profits.
• No more than $2 million of forgiven debt can be excluded from income.
• To be eligible for the break, the loan must be secured by your principal residence and the money must have been used to buy, build, or substantially improve the property. If part of the forgiven debt was a home equity loan used for other purposes, for example, that part would be considered taxable income.
• The tax basis of the home is reduced by the amount of canceled debt excluded from income. The basis is the amount you compare to the selling price of the home to determine if you have a profit or loss. (And, for tax purposes, a foreclosure is treated the same as a sale.) If a loan restructuring results in cancellation of $25,000 of debt, for example, your basis would be reduced by $25,000… potentially increasing by up to $25,000 the amount of profit you realize when you later sell. (The basis reduction will usually have no tax impact, though, because most home sale profit is tax-free.)

1099-C Confusion

While the new law offers important relief for strapped homeowners, it won’t prevent lenders who forgive debt from sending out 1099-C forms to taxpayers, with copies to the IRS. It will be up to you to know whether or not the discharged debt reported on the form is taxable or tax free.

The 1099-C must show the amount of debt forgiven and the fair market value of property given up through foreclosure. The IRS urges borrowers to check the form carefully and notify the lender immediately if any of the information shown on their form is incorrect. Pay particular attention to the amount of debt forgiven (Box 2) and the value listed for your home (Box 7).

How short sales work

Sometimes, rather than pursuing the costly and time-consuming process of foreclosure, a lender will allow a delinquent borrower to sell the house for less than the mortgage amount and turn the proceeds over to the bank as payment in full. Scott Williams, a real estate agent in Roseville, Calif., near Sacramento, explains how it works:

Say you lost your job and can’t keep up payments on your home, you still owe $300,000 on your mortgage but the house value has dropped to $275,000. If the bank agrees to a short sale, you’d sell the place, pay the commission and other selling costs—let’s assume $15,000—and turn the remaining $260,000 over to the bank. The $40,000 gap between the payment and the amount due would show up on a 1099-C form. That’s right, even the $15,000 of selling expenses gets tossed in with the amount of forgiven debt.

Thanks to the new law, when the short sale in 2007, 2008 or 2009 involves a principal residence, the canceled debt is not considered taxable income. Williams says he was actively involved in short sales in the 1990s housing slump in California, but that the practice pretty much disappeared for several years. Now it’s back with a vengeance.

“Most of these cases are homes that were purchased within the past couple of years, at or near the peak of the market,” he says. “Most were purchased with 100% financing or creative loans that after two years of artificially low payments, the loan adjusts to market rates. That can add hundreds of dollars to the payment and some of the people just can’t plain afford it.”

Banks don’t always agree to a short sale—among other things, they look at the gap between the balance on the loan and the expected proceeds of the sale and the homeowner’s other assets. But Williams says banks have become more receptive as the number of homeowners in trouble has grown. They weigh the cost of a short sale against the cost of foreclosing and selling the property themselves.

“Banks don’t do short sales because they want to be nice to people,” the agent says. “They do them because they make business sense.”

Dodging the tax bullet

Even if you’re not covered by the new tax-relief rule—say the house you lost was a vacation home rather than a principal residence—there’s a very important exception to the debt-relief-equals-taxable-income rule. Although lenders must send 1099-C forms reporting taxable income whenever canceled debt is $600 or more, the tax bill itself is forgiven if you are in bankruptcy or are insolvent.

Insolvency means your debts (including that mortgage) exceed the value of all your assets. You use IRS Form 982 to claim the exclusion.

Updated for tax year 2007