Residential Foreclosures, Short Sales, Cancellation of Debt, and Abandonment of Residential Property
Foreclosure
When you lose your home to foreclosure, or the property is given back to the lender (Deed in lieu of foreclosure), a deemed sale or exchange has taken place under IRC Section §1001(a) of the Internal Revenue Code. This sale or exchange of property could result in a gain or loss, and the recognition of cancellation of debt (COD) income to the taxpayer. Cancellation of debt will result in taxable income to the taxpayer unless there is an exception within the statute.
What that means is that you will pay income tax on that amount of canceled debt as if you earned income.
Deemed Sale
When an asset is sold, the difference between the amount realized and the taxpayers "adjusted basis" in the asset will determine the amount of the gain or loss recognized. The Amount realized will either be the fair market value of the property (FMV) or the face value of the debt, depending on whether the debt is classified as recourse or non-recourse. Accordingly, if the debt is non-recourse, the amount realized is going to be the face value of the debt, creating more gain, but no cancellation of debt income. Conversely, if the debt is recourse, less gain is recognized, because the FMV of the property as of the sale date, is used instead, but there is the possibility of recognizing COD income. The COD income amount will be the difference between the Face value of the debt and the FMV of the property.
Keep in mind that is is possible that your debt was not completely canceled, whereby the debt was sold to a third party or the bank sought a judgment against you for the deficiency.
Although the COD income may be excludible under one of the exceptions, it is taxed at a higher ordinary income rate than the capital gain rate of the asset sale.
Statutory Exclusions Under IRC Sec §108:
The exclusions to income recognition pertaining to your residential foreclosure, will be the insolvency, the "qualified principle residence" and the bankruptcy exclusions to Section §108 of the Internal Revenue Code. As to the amount of your "insolvency," or the amount your liabilities exceed the value of your assets that you own, on the day before the debt was forgiven, you are exempt from recognizing income on your debt forgiveness.
PENSION PLAN: When applying the insolvency test of § 108(d), a taxpayer's interest in a pension plan or other assets that are exempt from creditor's claims should be included as assets of the taxpayer. An interest in a pension plan should be valued in accordance with the principles described below.
1099 as Evidence of Amount of Canceled Debt:
The 1099-C/A that you will receive from the bank may not be correct, and does not establish a legal presumption of correctness (depositive) if the taxpayer can assert a reasonable dispute to the item of income on the 1099. The burden then shifts to the IRS under case law and Section 6201(d) of the Internal Revenue Code, to produce reasonable and probative information supporting the legitimacy of the 1099 amount. The IRS will often refuse to adjust the amount in their computer system without the issuance of a revised 1099 from the bank. Banks are reluctant to do this, and often your efforts to get a bank employee on the phone that is capable of implementing the change is unlike.
An entity required to report under § 6050P should subtract the proceeds of a foreclosure sale, settlement, etc. from the total debt in arriving at the amount of debt cancelled to be reported in Box 2 of Form 1099-C; this is not always done.
When the IRS receives Forms 1099-C reporting cancellation of indebtedness for each person with joint and several liability on an indebtedness, the IRS should not treat the full amount of the indebtedness cancelled as income to each separate taxpayer. Instead, a determination should be made as to the appropriate amount of discharged debt allocable to each taxpayer that is jointly and severally liable, taking into account all the facts and circumstances.
The IRS should not issue Forms 1099-C when canceling tax debt of individuals discharged in a bankruptcy case or as a result of an offer in compromise under § 7122.
Reporting of cancellation of indebtedness is not required with respect to guarantors and sureties on an indebtedness. How the discharged indebtedness should be treated as to each surety or guarantor, if reported, will be addressed in a separate memorandum.