I. The Basic Idea: Cancellation Of Debt Income
Let’s first understand the basic idea with a simple non-real estate example. Suppose you owed me $100,000. I’m such a nice guy that I forgive the debt. It turns out that this becomes a mixed blessing because now the IRS and the Franchise Tax Board (FTB) both will demand that you pay income tax on the $100,000. Why? Their reasoning (this is well-established law with a pedigree going back many decades): My forgiving you the $100,000 debt was economically equivalent to your earning $100,000 and paying me off. Or put another way, when I forgave the debt you got a $100,000 benefit. This benefit is then credited to you as income. It is sometimes referred to as cancellation of debt income, or imputed income from discharge of indebtedness, and with a few exceptions (that I’ll discuss below) it is taxable income.
II. Post-Short Sale/Post-Foreclosure Sale Cancellation Of Debt Income
Let’s apply the basic idea we just developed to the loss of your home in a short sale or a foreclosure sale. For simplicity let’s assume you have just one mortgage. Suppose, for example, that you owe $450,000 and the house sells for $350,000 – this kind of short fall is not all that unusual these days. Then the bank came up short by $100,000 after the sale.
A. The Short Sale
When you sell your home in a short sale, the bank agrees to accept less than you owe, with the understanding that the bank will not try to sue you to collect the post-sale deficiency. However, since the bank will want to use its $100,000 loss to offset its other income, and thus reduce its tax liability, it will not agree not to report the loss to the taxing authorities. When the IRS and the FTB get wind of the loss, they will come after you for the tax on the cancellation of debt income.
B. The Foreclosure Sale
In California we have an anti-deficiency statute found in Cal. Civ. Proc. Code § 580(b) (http://). The gist of it is that if you lose your home in a foreclosure sale, the foreclosing entity that lent you the money to buy the house in the first place – almost always the holder of the first mortgage – cannot come after you to collect the post-sale deficiency. What will it do? Based on the previous discussion it should be obvious that bank will report the loss to the taxing authorities to get the write-off. And now you owe tax on the cancellation of debt income.
III. Some Carve-outs In The Tax Codes
The Internal Revenue Code has five important carve-outs that waive cancellation-of-debt income tax. They are are found in 26 U.S.C. § 108(a). These carve-outs are incorporated into California tax law by Cal. Rev. & Tax Code § 24307(a).
The five carve-outs are:
- the discharge occurs in a bankruptcy,
- the discharge occurs when you were insolvent,
- the indebtedness discharged is qualified farm indebtedness,
- in the case of a taxpayer other than a C corporation, the indebtedness discharged is qualified real property business indebtedness, or
- the indebtedness discharged is qualified principal residence indebtedness which is discharged before January 1, 2013.
Based on the first carve-out, any debts that are discharged in bankruptcy do not give rise to cancellation of debt income. You can discharge any amount of debt in bankruptcy and not owe a dime in taxes on that cancellation of debt income. (Here’s my little chest-beating for this blog post: I once got rid of $2,000,000 for a single debtor in a Chapter 7 bankruptcy, and he owed zero in cancellation of debt income tax.)
Therefore, if you think you’re going to lose your house anyway, why not file for bankruptcy protection and surrender the property as part of the bankruptcy? You’ll end up not owing anything on the house, and you won’t owe cancellation of debt income taxes.
Important Caveat: The debt must be discharged in the bankruptcy. If you already lost your house in a short sale, or a foreclosure sale, before you filed the bankruptcy papers, then this carve-out won’t help you.
The second carve-out applies if you are still insolvent immediately after the debt was forgiven. If you’ve already lost your home and didn’t file for bankruptcy before the loss, you should talk to a competent tax professional to determine whether this carve-out applies to you.
If you lost your home in a short sale, or a foreclosure sale, then the third and fourth carve-outs don’t apply to you.
The last carve-out could still give you relief. It is a temporary one that expires on January 1, 2013, and only applies to “qualified principal residence indebtedness.” The meaning of that phrase is a bit complicated, but the gist is that the forgiven debt must have been purchase-money debt – i.e., you incurred the forgiven debt to buy the house in the first place, or if you refinanced, every penny of the refi went into home improvement. Thus, if you used the house as an ATM machine to get money to do something like take a vacation – a lot of people did this when real estate prices were high – then this carve-out doesn’t apply to you.
Finally, you may have had a capital loss associated with the sale, that could help to offset the cancellation of debt income. Consult a tax professional to see if this applies to you.
In sum, the only sure-fire way to avoid cancellation of debt income tax is to have the debt in question cancelled – i.e., discharged – in bankruptcy.