Taxing times: tax aspects of foreclosures and 'short sales'.

• Author: Fogel, David M.
• Position: Taxissues

California experienced a record 800,000-plus foreclosures in 2008, according to RealtyTrack. Since various foreclosure related tax laws have changed, here's what you need to know.

The Basics

In a foreclosure, the lender exercises its security interest in the property, takes the properly and sells it at a foreclosure sale. If the sales price does not meet the indebtedness, the lender may or may not hold the borrower liable for the difference. In a "short sale," the properly is sold to a third party and proceeds go to the lender, which cancels the debt.

A debt is nonrecourse if the lender cannot hold the borrower liable for it and may go only against the value of the property to collect (example: purchase money mortgage where the borrowed funds are used to purchase the home). A debt is recourse if the lender can hold the borrower liable for it beyond the value of the property (examples: second mortgage, refinance loan, line-of-credil loan).

Forms 1099-A or 1099-C are issued by lenders to report the income tax consequences of a foreclosure, short sale, abandonment or deed in lieu of foreclosure. If a lender acquires the property and does not cancel any debt, Form 1099-A is issued. If the lender cancels part or all of the debt, Form 1099-C is issued.

Tax Consequences

If a lender discharges any part of a debt, the taxpayer must recognize that amount as ordinary income [IRC Sec. 61 (a)( 12)].

When a nonrecourse debt is canceled in exchange for the property the transfer is treated as a sale [Commissioner v. Tufts, 461 U.S. 300 (1983); Reg. Sec. 1.1001-2(a)(1)]. The amount realized from the sale is the greater of the sales price of the property or the unpaid debt.

Where the debt is recourse, the transaction is split, into two parts:

1. ) A taxable disposition of the property; and

2. ) To the extent the fair market value (FMV) of the property is less than the unpaid debt, either a continuing debt obligation is owed to the lender or the remainder of the debt is discharged [Reg. Sec. 1.1001-2(a)(2)].

[ILLUSTRATION OMITTED]

The gain or loss on the taxable disposition portion is the difference between the property's FMV and the taxpayer's adjusted basis. If the lender cancels the remainder of the debt, the borrower will have cancellation of debt income (CODI) equal to the difference between the amount of the debt and the property's FMV

If the borrower qualifies, one of the relief provisions available under IRC Sec. 108 may be used to exclude the CODI. A...