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Important Tax Considerations in Foreclosures, Short Sales, and Deeds-in-Lieu of Foreclosure

By Yulissa Zulaica

How do you determine capital gains?

Capital Gains or losses = Amount Realized (AR) – Adjusted Basis (AB)

How do you determine whether there is income from cancellation of debt from a foreclosure, deed in lieu of foreclosure or short sale?

Cancellation of debt (COD) income is defined as the amount by which the canceled debt is more than the fair market value of the property which was used to secure the loan. COD income can occur when a bank forgives part of a debt to which a person was personally liable.

Exceptions to Cancellation of Debt Income: Insolvency Bankruptcy Mortgage Debt Forgiveness Act of 2007 Certain farm debts Non-Recourse Loans

Primary Residence versus Investment property: Capital losses resulting from the sale of a primary residence are not deductible. However, a person may still incur capital gains on the sale of her/his primary residence if the amount realized was greater than the person’s adjusted basis. It is important to note, however, that there is a $250,000 capital gain exclusion which a person may elect to apply. In order to qualify for this exclusion they must have lived in the home for 2 years over the last 5 years, which does not have to be consecutive, and the home must be the person’s primary residence.

Capital losses resulting from the sale of an investment property on the other hand, are deductible against capital gains, if they are available. Generally, capital losses may be applied towards ordinary income, but only up to a maximum of $3,000 per year ($1,500 if married filing separately) and the remaining capital losses may be carried forward. However, when dealing with rental property, by definition, all rental activities are considered passive and passive activity gain and loss are treated differently. Generally, passive activity gains and losses are netted against each other. If the passive activity income exceeds the available passive activity loss then it is income to the taxpayer. If the passive activity loss exceeds the income then the losses that exceed the available income will be suspended and carried forward until there is passive activity income to offset said loss. Additional limitations to this rule exists which depend on the taxpayer’s adjusted gross income and/or level of participation.

In sum, a person seriously considering a foreclosure, deed in lieu of foreclosure and/or short sale should discuss the potential tax consequences of a specific transaction with a tax attorney and/or accountant.

Recourse Loans versus Non-Recourse Loans: A recourse loan is a loan in which the borrower may be personally liable. A non-recourse loan is a loan which is usually secured by collateral and in which a borrower may not be held personally liable if the collateral does not satisfy the full value of the amount owed.

In a recourse loan, the Amount Realized (AR) is the canceled debt up to the fair market value of the property. In a non-recourse loan, the AR is the full amount of the debt. The gain or loss in either type of loan is calculated by subtracting the adjusted basis from the amount realized. To see why it is important to determine the type of loan and the type of property, see examples below.

Example 1:

Non-Recourse Loan

Facts: A buys a condo for $200,000. A puts $15,000 down and obtains a loan of $185,000.

The bank foreclosed on the loan and at that time the vale of loan was $180,000. Fair market value of the property was $170,000. A’s adjusted basis in the property was $175,000 (due to casualty loss she had deducted).

Results: A has a $5,000 gain, the amount by which A’s adjusted basis in the condo exceeds its fair market value. Whether or not it is a taxable gain will depend on whether A qualifies for and elects to use part of the capital gains exclusion amount.

There is no income from cancellation of debt for non-recourse debt.

Example 2: Recourse Loan

Facts: Same as above.

Results: A has a $5,000 capital loss, the amount by which A’s amount realized, which is equal to the property’s fair market value, exceeds A’s adjusted basis in the condo, and a $10,000 or ordinary income derived from the debt cancellation. The income is derived from subtracting the amount realized ($170,000) from the total amount of the debt ($180,000).

A cannot deduct the capital losses if the condo is her or his primary residence. If it is an investment property, however, A can use capital gains to offset capital losses subject to the loss limitations discussed above.

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