Taxing Times For Distressed Property Transactions

By Phillip C. Querin, QUERIN LAW, LLC Website: E-Mail: (Disclaimer – The following is for informational purposes only. I am not a tax lawyer or CPA. In all cases of debt cancellation, readers are strongly encouraged to seek competent advice from a tax professional familiar with their specific situation. The material below is a summary only. For specifics consult your tax advisor. - PCQ) One of the basic rules of tax law is that cancellation of debt is a taxable event. For the lay person, cancellation of debt is the same as forgiveness of debt. It makes no difference how the cancellation occurred. It could be voluntary – through a short sale or deed in lieu of foreclosure, or certain loan modifications - or involuntary – through a foreclosure. In the tax lawyer’s lexicon, “cancellation of debt” is referred to as “COD” - like the fish – just harder to swallow. However, with the housing and credit crisis forcing many people into foreclosure and pre-foreclosure events that resulted in significant debt cancellation, the federal Mortgage Debt Relief Act of 2007 was passed. Subject to certain exceptions, this law permits taxpayers to exclude taxable income arising from the discharge of debt on their principal residence. It also applies to certain loan modification events where the debt is either forgiven, or restructured in a significant manner, such that it triggers a taxable event. For many taxpayers, this new federal law was a “codsend,” if you will. Features. Here are some of its main features 1:
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It applies to debt forgiven in calendar years 2007 through 2012. Up to $2 million of forgiven debt is eligible ($1 million if married filing separately). The debt must be secured by the taxpayer’s primary residence. It does not appear to make any difference whether the debt is secured by a first mortgage/trust deed or subordinate mortgage/trust deed. However, the debt must be used to buy, build or substantially improve the primary residence. This is known as “qualified principal residence indebtedness.” A home equity line of credit secured by a primary residence would qualify, but only to the extent that the funds were used to build, buy, or substantially improve the primary residence. You can only have one principal residence at a time. The IRS uses the same analysis under this law as that for a “primary residence” under IRC 121 (the $250,000/$500,000 gain exclusion law). Refinanced debt is eligible to the extent that it replaces only the existing qualified principal residence indebtedness. Any portion of the refinancing used for other purposes would be treated as taxable COD income. Lenders or creditors cancelling debt will issue IRS Form 1099-C to the taxpayer identifying the amount reported to the IRS for the year of the cancellation.


Note: This is a short summary of some, but not all, of the features.


IRS Form 982 is used by taxpayers to claim the exemption.

Exclusions. Here are some of the main exclusions from COD taxes:
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Debts discharged through bankruptcy. Insolvency at the time of the cancellation of debt. However, some of the cancellation may remain taxable, as it is apportioned against the insolvency. Insolvency is defined as one’s total debts exceeding the fair market value of one’s total assets. (The insolvency exclusion applies to residential or nonresidential COD.) If the debt is “non-recourse,” meaning that the creditor’s collection remedy is limited to the property itself – not the taxpayer – COD does not generally apply (although other tax events may be triggered).

Warning. Although I’ve not seen it discussed in the context of today’s many distressed housing issues, there appears to be an implicit pitfall buried in the IRS’ principal residence exclusion. It bears keeping in mind. Remember that the exclusion expires at the end of 2012. When an actual foreclosure is completed in the year of sale, the COD event occurs in that year, and so long as it was completed before 2013, the exclusion applies. The same holds true for short sales and deeds-in-lieu, where the debtor and creditor formally agreed that the remaining unpaid indebtedness was cancelled or forgiven before 2013. However, in those cases in which the parties reached no express agreement about forgiveness of remaining debt, another COD event can potentially occur. Specifically; (a) when the creditor’s (express or implied) internal policies require the termination of further collection activity, or (b) when the debtor successfully asserts in court a statute of limitations defense to the collection of the debt, there is a taxable COD event. This is a major reason why homeowners must reach agreement with their lender at the conclusion of a short sale or deed-in-lieu before 2013. Unless the current law is extended, the failure to complete the COD event by December 31, 2012 could result in the homeowner having to realize a tax on the “phantom income” they thought was forgiven and excluded between 2007 and 2012. ©Copyright 2011 QUERIN LAW, LLC.


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