As home owners throughout our nation have struggled to either retain their properties or minimize the damage in losing them, they have looked towards a patchwork of government programs for help.  These programs such as Hope for Homeowners, HAMP, and now HAFA have promised a lot but delivered very little results so far.  The one effective relief program has been the Federal Debt Foregiveness Relief Act and comparable State laws which enables homeowners to avoid taxes on the forgiven debt on their principal residence.  No such program has been created to protect investors but… relief from these taxes may be available anyway.

Debt Forgiveness Tax arises anytime a lender is not paid in full on a loan. Typically, this is measured by the lender issuing an IRS 1099 for miscellaneous income showing what was owed and what was paid. You get taxed on the difference as income unless some exemption applies. There are several.

1.  Capital Loss Offset - When you buy a property, your purchase price generally establishes your “taxable basis”, ie: what you invested. This is increased by capital improvements you make, such as a new roof, and it is decreased by your depreciation write off.  For many investors, your taxable basis may be much higher than the current market value and higher still than the amount owed on the property. For example, if you purchased for $500,000 with a $400,000 loan and the property sells or is foreclosed at a price of $250,000 (not uncommon); then you would have a debt forgiveness of $150,000 (amount of loan unpaid in the sale) but you would also have a capital loss of $250,000 (amount invested less sale price).  Accountants are generally in agreement that you can offset the debt forgiveness tax with the capital loss. In this example, the result would be elimination of the debt forgiveness tax and a carry-over remaining capital loss of $100,000 which could be applied against other investment losses. 

2.    IRS Insolvency Exclusion - In my February 19th posting, I wrote about how the Insolvency Exclusion works as detailed in IRS Publication 4681 “Cancelled Debts, Foreclosures, Repossessions, and Abandonments”. http://www.irs.gov/pub/irs-pdf/p4681.pdf.  The important point is that this Exclusion applies equally to homeowners as well as investors.  In short, you list all of your liabilities and below that list all of your assets. If your liabilities are greater than your assets, you are “Insolvent” for debt forgiveness purposes and can avoid the debt forgiveness tax. Many States, including California, have adopted the IRS Exclusion to apply to State debt forgiveness taxes as well.

3.  Bankruptcy - although this is a last resort for owners and investors alike, if a property is lost during the pendency of the Bankruptcy there will be no debt forgiveness tax applied. You cannot use BK to avoid taxes already incurred before the Bankruptcy is filed.

Before you make any decision concerning your upside-down home or investment property, be certain to get tax and legal advice from qualified professionals in your area who can look at your specific situation and advise you on how these rules apply to you.  This Article is solely intended to give you an introduction to what might be available for you but you should not rely on it to apply to your financial circumstances.

If you have specific questions about your liability, foreclosure, or any legal issue, feel free to contact me at sjbeede@bpelaw.com.  Need help Coping with an Upside Down Loan? Checkout Steve’s audio-seminar and e-book at: http://www.stevebeede.com/copingwithanupsidedownmortgage/.

 has been the investor market

Over the past year, I have posted numerous Articles which in part deal with Debt Forgiveness and the receipt of a 1099 form from a lender.  Now, as we’re seeing lawsuits being filed by some lenders to collect on unpaid debt after foreclosure, borrowers are saying “Wait… they gave me a 1099! Doesn’t that mean the debt is forgiven?” The answer is maybe.

A 1099 is simply a type of IRS form used to report income other than wages, salaries, and tips. The most common forms are:  1099-Misc to report miscellaneous income; 1099-Div to report dividend income; and the 1099-Int to report interest income.  Following foreclosure two different forms of 1099 are used: the 1099-C to report cancelled debt; and the 1099-A to report the acquisition or abandonment of a secured property. It is this last one that causes the confusion and no doubt will be the subject of litigation.

The 1099-A contains several boxes, one of which requires the lender to state whether the borrower was personally liable for the debt or not.  If there is no liability (such as in California with acquisition debt or following the lender’s Trustee Sale), then the unpaid debt amount is forgiven and debt forgiveness tax can be assessed (unless an exclusion applies). This gives the same result as the 1099-C. But… where the 1099-A states that the borrower is personally liable, then the filing of the 1099-A  might not mean debt is forgiven. Rather, it may mean that the lender has only filed the form to designate that an event has occurred and they have not as yet determined whether or not to cancel, ie: forgive, the debt. This is a very confusing result. 

You can learn more about the use of 1099-C and 1099-A on IRS Publication 4681: http://www.irs.gov/pub/irs-pdf/p4681.pdf. For any of you Accountants reading this, if you can shed more light on this, please post a Reply or e-mail me at sjbeede@bpelaw.com.

Watch this Blog for further insight as this issue gains greater clarity. We’re just starting to provide defenses for borrowers sued by wiped out junior lenders and the role of the 1099 may be an important defense argument (as well as the many other defenses that may exist).  Remember, lenders want to try to get paid but they don’t want to throw good money after bad. If there is some recourse, a settlement may be the fastest and most cost-effective result for everyone.

If you’re facing a post-foreclosure lawsuit or have any questions concerning upside-down loans or your rights and obligations concerning real property, foreclosure, or any related issues, please feel free to contact me at stevebeede@bpelaw.com or contact my office at 916 966-2260 for a confidential appointment by phone or in person.

A lot of mis-information appears to be circulating on the web concerning how the debt forgiveness tax relief is applied. “Debt Forgiveness” occurs anytime you don’t have to pay back a debt that you owe someone. In today’s world, that most commonly occurs through a foreclosure or a short sale when a lender or lenders are not paid in full. Unless the lender is pursuing a judgment for the deficiency (which is rare), our IRS Code states that the amount not paid, ie: forgiven, is taxable income to the borrower.  In December, 2007, the Federal government passed the Mortgage Forgiveness Debt Relief Act which provided that if you incur debt forgiveness between 2007 and 2012 on your principal residence there will be no tax. Some States have adopted similar provisions to deal with state taxes.  What has become confusing is what is meant by “principal residence”.

Several writers on the web have stated that the test for Principal Residence is that you lived in the property for 2 of the last 5 years. If this were true, then the forgiveness might be available even if the property is now rented out.  So, this is significant.  The “2 out of 5 years” rule is the test for capital gains tax exclusion and is used to determine whether you would have to pay capital gains tax when the property was sold or foreclosed. But this is a different question from debt forgiveness. Capital gains measures the difference between what you paid for the property (taxable basis) and what it sold for (short sale or foreclosure sale). So, if someone has owned their property a long time and refinanced well above their taxable basis, then the “sale” price could result in a capital gain tax to which the 2 out of 5 year rule would apply.  Ambiguities in explanations of the Mortgage Forgiveness Debt Relief Act have led some to conclude that the determination is made by using the capital gains rule on personal residence.  I do not believe that this is accurate. More importantly, this mis-information could leave debtors exposed to debt forgiveness tax.

When it comes to tax questions, it is valuable to examine what the IRS has to say on the issue because if they disagree with what you claim, you’re in for a nasty and costly fight. Luckily, the IRS appears to have answered this question.

IRS Publication 4681 “Cancelled Debts, Foreclosures, Repossessions, and Abandonment” is available for download at http://www.irs.gov/pub/irs-pdf/p4681.pdf. In this Report, the IRS explains how this is treated. At Chapter 1 “Cancelled Debts”, Page 7, the IRS defines what constitutes “Qualified Principal Residence Indebtedness” which is the criteria to avoid the debt. It clearly defines this as “the home where you ordinarily live most of the time. You can have only one principal residence at any one time”. There is nothing whatsoever that provides for a 2 of 5 year definition.

Based upon this, it seems conclusive to me that the IRS will only grant debt forgiveness on the home where you ordinarily live at the time that the debt forgiveness occurs.  Of course, reasonable people could reach different conclusions.  If you are facing a debt forgiveness event, be certain to get competent legal and tax advice.

The Federal Debt Forgiveness Relief Act passed in December 2007 enables owner-occupants to avoid the tax on debt that is forgiven by lenders following a short sale, deed in lieu, or foreclosure. The Federal program runs through 2012.  However, California’s similar law ended in 2008 meaning that such debt forgiveness will be taxed in California. You can find out how to claim the exemption for 2008 at http://www.ftb.ca.gov/aboutFTB/newsroom/Mortgage_Debt_Relief_Law.shtml

The real question is whether California will follow the Fed’s lead and extend the relief out till 2012.  However, help may be on the way. In January, 2009, Assemblyman Roger Niello introduced AB 111 which would extend the relief out to December 31, 2012. The bill which was amended on March 5th is now moving its way through the state legislature and is with the Committee on Revenue and Taxation. The next hearing is scheduled for April 13th.  You can track its status at http://www.leginfo.ca.gov/cgi-bin/postquery?bill_number=ab_111&sess=CUR&house=B&author=niello. 

If you have questions about coping with upside down loans or issues of debt forgiveness, you can e-mail Steve at:  sjbeede@bpelaw.com

Most people are aware of the risk of lenders coming after them for a deficiency judgment after a foreclosure and they know how this may be avoided.  But few people understand or appreciate the tax liability that also can occur with any unpaid loan. But there also are times that this is avoidable.

Under our Federal Tax Law, anytime you owe money to someone else and then don’t have to pay it, “debt forgiveness” occurs (unless the lender gifts the debt to you which is not likely). The IRS says if you owed it, you must have had the money to pay it. So, if you got to keep that money, it must be income that they can tax you on.  That’s right, even if you never had this “phantom income”, it is taxable if the lender doesn’t get paid in full whether due to foreclosure, deed in lieu, or even a short-sale.  Although generally the foregiveness is shown by the lender giving you a 1099 tax form, the tax code doesn’t require this.  So, if your home short-sells for $100,000 less than you owed, you now have $100,000 of taxable income….maybe.

In December, 2007, the Federal Government passed The Mortgage Forgiveness Debt Relief Act of 2007 which generally excludes debt forgiveness from taxation if  it occurs on your principal residence from 2007 through 2013 (there are some restrictions).   Many states have adopted similar laws providing the same relief for state taxes. However, California’s similar law ended 12/31/08. We’re awaiting a bill to extend it but with CA’s budget mess, this may not happen soon if at all.

So, they key point is that the Relief only applies on the home you actually live-in. If you rent out your home or leave it vacant and go live somewhere else. Your debt forgiveness relief may be lost and you may be looking at a high income tax bill from the IRS and your state.

If you need further assistance or have legal or real estate questions, feel free to e-mail me at sjbeede@bpelaw.com