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Questions and Answers on Home Foreclosure and Debt Cancellation

Update Feb. 4, 2008 — The Mortgage Forgiveness Debt Relief Act of 2007 generally
allows taxpayers to exclude income from the discharge of debt on their principal
residence. Debt reduced through mortgage restructuring, as well as mortgage debt
forgiven in connection with a foreclosure, qualify for this relief.

This provision applies to debt forgiven in 2007, 2008 or 2009. Up to $2 million of
forgiven debt is eligible for this exclusion ($1 million if married filing separately). The
exclusion doesn’t apply if the discharge is due to services performed for the lender or
any other reason not directly related to a decline in the home’s value or the taxpayer’s
financial condition.

The amount excluded reduces the taxpayer’s cost basis in the home. More information
on claiming this exclusion will be available soon.

The questions and answers, below, are based on the law prior to the passage of the
Mortgage Forgiveness Debt Relief Act of 2007.

1. What is Cancellation of Debt?

If you borrow money from a commercial lender and the lender later cancels or forgives
the debt, you may have to include the cancelled amount in income for tax purposes,
depending on the circumstances. When you borrowed the money you were not
required to include the loan proceeds in income because you had an obligation to
repay the lender. When that obligation is subsequently forgiven, the amount you
received as loan proceeds is reportable as income because you no longer have an
obligation to repay the lender. The lender is usually required to report the amount of
the canceled debt to you and the IRS on a Form 1099-C, Cancellation of Debt.

Here’s a very simplified example. You borrow $10,000 and default on the loan after
paying back $2,000. If the lender is unable to collect the remaining debt from you, there
is a cancellation of debt of $8,000, which generally is taxable income to you.


2. Is Cancellation of Debt income always taxable?

Not always. There are some exceptions. The most common situations when cancellation
of debt income is not taxable involve:

Bankruptcy: Debts discharged through bankruptcy are not considered taxable income.
Insolvency: If you are insolvent when the debt is cancelled, some or all of the cancelled
debt may not be taxable to you.You are insolvent when your total debts are more than
the fair market value of your total assets.Insolvency can be fairly complex to determine
and the assistance of a tax professional is recommended if you believe you qualify for
this exception.
considered taxable income.The rules applicable to farmers are complex and the
considered taxable income.The rules applicable to farmers are complex and the
assistance of a tax professional is recommended if you believe you qualify for this
exception.
exception.

Non-recourse loans:A non-recourse loan is a loan for which the lender’s only remedy in
case of default is to repossess the property being financed or used as collateral.That
is, the lender cannot pursue you personally in case of default.Forgiveness of a non-
recourse loan resulting from a foreclosure does not result in cancellation of debt
income.However, it may result in other tax consequences, as discussed in Question 3
below.


3. I lost my home through foreclosure.  Are there tax consequences?  

There are two possible consequences you must consider:

Taxable cancellation of debt income.(Note: As stated above, cancellation of debt
income is not taxable in the case of non-recourse loans.)
A reportable gain from the disposition of the home (because foreclosures are treated
like sales for tax purposes).(Note: Often some or all of the gain from the sale of a
personal residence qualifies for exclusion from income.)
Use the following steps to compute the income to be reported from a foreclosure:

    Step 1 - Figuring Cancellation of Debt Income (Note: For non-recourse loans,
    skip this section.  You have no income from cancellation of debt.)

    1. Enter the total amount of the debt immediately prior to the foreclosure.
    ___________
    2. Enter the fair market value of the property from Form 1099-C, box 7.
    ___________
    3. Subtract line 2 from line 1.If less than zero, enter zero.___________

    The amount on line 3 will generally equal the amount shown in box 2 of Form
    1099-C.  This amount is taxable unless you meet one of the exceptions in
    question 2.  Enter it on line 21, Other Income, of your Form 1040.

    Step 2 – Figuring Gain from Foreclosure

    4. Enter the fair market value of the property foreclosed.For non-recourse
    loans, enter the amount of the debt immediately prior to the foreclosure
    ________
    5.    Enter your adjusted basis in the property.(Usually your purchase price
    plus the cost of any major improvements.)                                    
    ____________
    6. Subtract line 5 from line 4.  If less than zero, enter zero.   

    The amount on line 6 is your gain from the foreclosure of your home.  If you have
    owned and used the home as your principal residence for periods totaling at
    least two years during the five year period ending on the date of the foreclosure,
    you may exclude up to $250,000 (up to $500,000 for married couples filing a joint
    return) from income.  If you do not qualify for this exclusion, or your gain exceeds
    $250,000 ($500,000 for married couples filing a joint return), report the taxable
    amount on Schedule D, Capital Gains and Losses.


4. I lost money on the foreclosure of my home.  Can I claim a loss on my tax return?   

No.  Losses from the sale or foreclosure of personal property are not deductible.  


5.  Can you provide examples?

A borrower bought a home in August 2005 and lived in it until it was taken through
foreclosure in September 2007. The original purchase price was $170,000, the home is
worth $200,000 at foreclosure, and the mortgage debt canceled at foreclosure is
$220,000. At the time of the foreclosure, the borrower is insolvent, with liabilities
(mortgage, credit cards, car loans and other debts) totaling $250,000 and assets
totaling $230,000.

The borrower figures income from the foreclosure as follows:

Use the following steps to compute the income to be reported from a foreclosure:

    Step 1 - Figuring Cancellation of Debt Income (Note: For non-recourse loans,
    skip this section.  You have no income from cancellation of debt.)

    1. Enter the total amount of the debt immediately prior to the foreclosure.
    ___$220,000__
    2. Enter the fair market value of the property from Form 1099-C, box 7.
    ___$200,000__
    3. Subtract line 2 from line 1.If less than zero, enter zero.___$20,000__

    The amount on line 3 will generally equal the amount shown in box 2 of Form
    1099-C.  This amount is taxable unless you meet one of the exceptions in
    question 2.  Enter it on line 21, Other Income, of your Form 1040.

    Step 2 – Figuring Gain from Foreclosure

    4. Enter the fair market value of the property foreclosed.For non-recourse
    loans, enter the amount of the debt immediately prior to the foreclosure.
    __$200,000__
    5.  Enter your adjusted basis in the property.(Usually your purchase price
    plus the cost of any major improvements.)                                        
    ___$170,000__
    6. Subtract line 5 from line 4.If less than zero, enter zero.___$30,000__

The amount on line 6 is your gain from the foreclosure of your home.  If you have
owned and used the home as your principal residence for periods totaling at least two
years during the five year period ending on the date of the foreclosure, you may
exclude up to $250,000 (up to $500,000 for married couples filing a joint return) from
income.  If you do not qualify for this exclusion, or your gain exceeds $250,000
($500,000 for married couples filing a joint return), report the taxable amount on
Schedule D, Capital Gains and Losses.

In this situation, the borrower has a tax-free home-sale gain of $30,000 ($200,000
minus $170,000), because they owned and lived in their home as a principal residence
for at least two years. Ordinarily, the borrower would also have taxable debt-
forgiveness income of $20,000 ($220,000 minus $200,000). But since the borrower’s
liabilities exceed assets by $20,000 ($250,000 minus $230,000) there is no tax on the
canceled debt.

Other examples can be found in IRS Publication 544, Sales and Other Dispositions of
Assets, under the section “Foreclosures and Repossessions”.


6.  I don’t agree with the information on the Form 1099-C.  What should I do?

Contact the lender.  The lender should issue a corrected form if the information is
determined to be incorrect.  Retain all records related to the purchase of your home
and all related debt.



7.  I received a notice from the IRS on this. What should I do?

The IRS urges borrowers with questions to call the phone number shown on the notice.
The IRS also urges borrowers who wind up owing additional tax and are unable to pay it
in full to use the installment agreement form, normally included with the notice, to
request a payment agreement with the agency.