Cancellation of Debt

Homeowners-Principal Residence (Foreclosure)

For homeowners who have lost their principal residence in foreclosure, the new laws have made it easier to handle cancellation-of-tax concerns. One is no longer required to prove insolvency or file bankruptcy to avoid the taxable income of debt cancellation. However, the debt must meet the rules (original purchase debt). Also, there could still be a capital gains issue even in a foreclosure. As a tax professional, be sure that you are well versed in these complex rules of reporting. The home must be lost in a foreclosure proceeding, and it must have been the taxpayer’s principal residence.

Homeowners-Principal Residence

(Short Sale or Abandonment)

For homeowners who lose their principal residence in a short sale, or for those who may have abandoned their property, the rules change. The debt cancellation may, in fact, be a taxable event requiring IRS reporting and possible taxes on the portion of debt that is cancelled (debt income). A short sale is not a foreclosure proceeding and the loss of the property is not directly attributed to a decline in value; it is “debt cancelled” because the home was sold for less than the amount of the loan to avoid the foreclosure process. Similarly, if the taxpayer were to simply abandon the property (walk away), the situation would be treated like a short sale. Short sales and abandoned property cancellation-of-debt issues require careful attention because of the many complicated rules in reporting and computing the tax impacts. In these cases, a taxpayer may avoid the taxes if they can meet the insolvency test requirements or if there is a connection with a bankruptcy proceeding.

Investors-Residential Rental (Foreclosure)

For investors who lose their property in a foreclosure, the rules are very different for reporting the cancellation-of-debt and possible capital gains. Determining the taxes on cancelled debt depends on numerous factors. First, the amount of suspended losses that have been carried forward must be determined, the amount of depreciation allowed (or allowable) must be determined, and then the issue of taxpayer insolvency needs to be resolved. The investor must follow a series of changing rules that set forth the priority of adjustments that can be claimed to reduce the potential taxable income from debt cancellation. Using Form 982, the taxpayer investor can elect to reduce, for example, unused depreciation in future years by an amount equal to the debt cancelled by the lender.To meet the insolvency test, a very complex series of asset-liability questions must be reviewed to determine the investor’s level of insolvency at the time of foreclosure. The investor can reduce taxable income from det cancellation by an amount equal to the amount they are insolvent, assuming they can meet the requirements of the insolvency test.

Investors-Residential Rental (Short Sale or Abandonment)

If the investor has lost the property in a short sale, or perhaps through abandonment, the tax professional must calculate how much of the debt cancellation may be taxable income. Similar to foreclosure, this involves a series of complex rules. Then, using offsets, the tax professional can decrease these amounts by reducing suspended losses, future depreciation, or by meeting the insolvency test requirements. Similarly, if the investor lost the property during the proceedings of a bankruptcy case, there are taxable-income exceptions. In short, when considering the issue of debt cancellation in foreclosure or short sale/abandoned property, the tax professional must take time and complete a careful analysis of all facts. This includes reviewing all documents, and understanding the reporting requirements of the IRS. Income from the cancellation-of-debt is not a simple matter, but more importantly a taxpayer could potentially face capital gains setbacks in any of the previous examples.

With the increase in home foreclosures, taxpayers are confronted with a myriad of complex rules about reporting the information to the IRS. We hope to provide you with some useful guidance in understanding what must be reported when filing tax returns for clients facing these issues.

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