Foreclosures, Debt Forgiveness and Mortgage Losses Explained

There’s a lot of good discussion on the Fix the Tax Code Friday comments thread about debt cancellation and mortgage debt cancellation relief. I started to reply to one of the comments and thought it was best to make it a separate post so that it doesn’t get buried.

I wanted to clarify some misconceptions about debt cancellation and mortgage debt cancellation due to a foreclosure. Every instance of debt cancellation – even for mortgages – is not the result of a foreclosure. Mortgages are very fact and circumstance specific since they are negotiated according to state law, an individual’s income and other considerations.

The new (temporary) law regarding mortgage debt forgiveness excludes the cancellation from income in most cases; eligible debt includes mortgage balances on principal residences which totaled less than $2 million. It’s also worth noting that the extension of the new law for mortgage debt forgiveness through 2012 does not apply to home equity loans.

However, this doesn’t mean that the prior law included the entire debt burden as income in every instance. The old law (still on the books and will kick back in after the reprieve in 2012) worked as follows:

A foreclosure is, for tax purposes, like a sale. The bank does not simply take back your house and then report the entire amount of your mortgage as income. There are two parts to calculating taxable income, one to determine the cancellation of indebtedness income, and one to determine any taxable gain.

The first part, to calculate income associated with the forgiveness of indebtedness value, is as follows:
1, Calculate the total amount of indebtedness prior to foreclosure.
2, Calculate the total fair market value (FMV) of the home.
3, Deduct line 2 from line 1.

If the indebtedness is less than or equal to the FMV of the home, there is no resulting income to report. As an example, if I owed $375,000 on a $400,000 home, there is no taxable income to me. If I owed $400,000 on a $400,000 home, there is likewise no taxable income to me.

Income is realized when a borrower has taken out more than the home is worth but only to the extent that the debt exceeds the FMV of the home. This usually happens when: (a) borrower overpaid for the home; (b) housing market drops (often corresponding with a, above); or (c) borrower has borrowed/refinanced for more than the home was worth (often with two or more mortgages).

The reason that there is reportable income when a borrower takes out more than the home is worth is because the bank loses the difference. If I have borrowed against my home for $500,000 but the bank can only recover $400,000, there is a loss to the bank. The bank does get to claim the loss as a deduction. And since the Tax Code is premised on the idea that income should be matched with deductions, there is corresponding income to the borrower equal, more or less, to the bank’s loss ($100,000 in my example).

The second part, to figure capital gain or loss on a foreclosure, is as follows:
4, Take the smaller of 1 or 2 above.
5, Figure your adjusted basis for the property (cost + improvements)
6, Your gain or loss is the difference after subtracting item 5 from item 4.

Treat any gain from a foreclosure just as if you had sold the home. So, if you owned and used the home as your principal residence for at least two of the last five years prior to the foreclosure, you can exclude gain of up to $250,000 (or $500,000 for married couples filing jointly). Any gain over the exclusion amount would be treated as capital gain. And just like with any sale of a primary residence, a loss on a foreclosure is not deductible on an individual tax return. In other words, you wouldn’t pay tax unless you had a significant gain at the foreclosure.

And we’re not done yet! There are two important exceptions to the above: If your debt is discharged through bankruptcy, there is no taxable income to report. And, if you are declared financially insolvent, meaning that your debts exceed the FMV of your assets, you may exclude some or all of the forgiven debt from income.

Make sense? I think that there was an impression that homeowners got slammed twice under the old law in every circumstance. I realize it’s somewhat complicated but the bottom line was that under the old law, so long as you borrowed less than or equal to your current asset values, you did not fall into the debt forgiveness/reportable income “trap.”

The new law has been regarded as rewarding those people who over-borrowed. The existing law did not affect folks who owed less than or equal to the value of their homes – just those who owed more than the value of the home.

Of course, this is a quick and dirty explanation of the prior law. Be aware that each situation is fact specific. For more on cancellation of debt income, you can check out the IRS publication 544 or, of course, consult with your tax professional.