I Received a 1099 from My Lender, Now
What?
Tax Consequences of Foreclosure or Short Sale of
Personal Residence in Arizona
By: Beth S.
Cohn
It is difficult to read any economic news or watch a local TV news
program without seeing the prevalence of foreclosures and short
sales of personal residences in Arizona. It is not uncommon
in today's economic crisis to own a home that was purchased in the
last five years that is substantially "upside down". Many
neighborhoods have more than one of these properties, driving down
the value of other houses in the neighborhood. Some people
have given up and don't want to keep paying mortgage payments on
houses on which their mortgage is double what the house may be
worth. Others simply cannot keep making the payments due to
an interest rate reset, hardship, or job loss. The step to
attempt a short sale or allow the bank to complete a foreclosure
sale is difficult. Either one may result in tax consequences
to the homeowner.
What is the Difference Between a Short Sale
and a Foreclosure?
A short sale is when a homeowner has certain financial or personal
hardships and enters an agreement with the lender to sell their
house for less than the amount of the outstanding mortgage on the
home. The balance of the obligation is forgiven by the lender
when the property is sold. The difference between a short
sale and a foreclosure is that in a short sale, the residence does
not go through a formal sale that is controlled by Arizona
statutes, commonly called either a foreclosure or a "Trustee's
Sale".
In a foreclosure, the lender, uses of a third party "Trustee" who
gives a 90 day notice that the property is going to be sold.
Until 5:00 p.m. of the day before the Trustee's Sale, the homeowner
can reinstate the loan by paying all prior payments, plus all costs
of the sale, including the Trustee's and their attorney's
fees. If the property goes to sale, the lender in many cases
may make the initial bid. If the house is sold at the
Trustee's Sale, for less than the amount of the outstanding debt,
the buyer could be the lender or a third party. Under Arizona
law, if the loan is considered a "purchase money" loan, the house
is on 2 ½ acres or less and is a single one family
or two family dwelling, the lender cannot go after a deficiency
(the shortfall between the outstanding debt and the sales price)
against the homeowner. A purchase money loan is defined as
using the proceeds of the loan to purchase the residence. In
Arizona, this is what is frequently referred to as the
"anti-deficiency" rules.
With the anti-deficiency rules, the homeowner walks away and does
not owe the lender any balance after the Trustee's Sale. The
anti-deficiency rules do not apply to home equity
credit lines where the money was not used to purchase the
residence. Other questions may arise if the existing loan is
a refinance of an original purchase money loan. These issues
are not being discussed in this article. They are complicated
and need separate review and analysis by an attorney.
How Do Short Sales or Foreclosure Impact How Much
Tax is Due?
In 2007, Congress passed the Mortgage Forgiveness Debt Relief Act
(the "Act"). The Act provides that homeowners can exclude
from income the discharge of "qualified principal residence
indebtedness" on the foreclosure or restructure of such debt on a
personal residence of up to $2 million (if married) or $1 million
(if married filing separately). A single person is not
directly addressed by the law. To determine whether the Act
applies on a foreclosure or a short sale of a personal residence in
Arizona, we have to examine if the homeowner has personal liability
for any portion of the debt when the transaction is completed.
In Arizona, if the loan on the house is considered a purchase
money loan and the homeowner does not have liability to pay the
loan, both a short sale and a foreclosure are not
considered "discharge of debt" for income tax purposes
under the Act. In both cases, the homeowner is treated as
having sold the residence.
The
following illustrations will help explain the tax consequences of a
short sale or a foreclosure of a personal residence in
Arizona. The assumptions are that the property is the owner's
primary residence, the loan is a purchase money loan and the
Arizona anti-deficiency rules apply.
Example 1
Purchase price was $300,000; balance of loan is $300,000 and
Short sale for $200,000
The sales price to a third party is
$200,000 and the lender forgives the balance of $100,000:
Result: Sales price is $300,000 and gain on
sale is $0. There is no gain on the sale of the residence and
no debt discharge income. There would be no tax
consequence.
Purchase price was $300,000; balance of loan is $300,000 and
Trustee Sale Bid for $300,000
Trustee's Sale and lender and/or
third party bids $300,000: There is no balance to
forgive.
Result: Sales price is $300,000 and gain on
sale is $0. There is no gain on the sale of the residence and
no debt discharge income. There would be no tax consequence.
The same result as the short sale.
Example 2
Purchase price was $400,000; balance of loan is $300,000 and
Short Sale for $200,000
The sales price to the third party
is $200,000 and the lender forgives the balance of
$200,000.
Result: Sales price on the house is $300,000
and the homeowner has a non-deductible capital loss of
$100,000. Losses on personal assets cannot be
deducted.
Purchase price was $400,000; balance of loan is $300,000 and
Trustee's Sale for $200,000
Trustee's Sale and a third party
successfully bids $200,000:
Result: Sales price is $300,000 and the
homeowner has a non-deductible capital loss of $100,000.
Losses on personal assets cannot be deducted. This is the
same result as a short sale.
In these examples, either a short sale or a foreclosure is
treated as a sale of the property for the amount of the debt for
tax purposes. A short sale may be a better option for tax
purposes if the loan is not a purchase money loan or there is a
home equity credit line. The tax consequences of a short sale
or a foreclosure for these types of loans where the Arizona
anti-deficiency statutes or the Act do not apply are not addressed
in this article.
Reporting Requirements
Whether a specific loan is discharged on the lender's books by a
short sale or a Trustee's Sale, the lender is required by the IRS
to issue a 1099-C for the forgiven portion of the loan to the
borrower. There is a box that the lender checks on the 1099-C
that indicates whether the borrower is personally liable or not
personally liable for the loan. On a purchase money loan for a
personal residence in Arizona, the lender should check the box that
states that the borrower is not personally liable
because of the Arizona anti-deficiency statutes. In this
case, the IRS should not be looking to match the 1099-C with the
taxpayer reporting income from forgiveness of indebtedness.
Any sale of a personal residence should be reported on Schedule D
of IRS Form 1040 if any portion of the gain on the sale is not
excluded under IRC § 121.
If the lender should make an error on the 1099-C, showing that the
borrower was personally liable, the borrower should contact the
lender and request that a corrected 1099-C be filed. IRS Form 982
is used for discharge of qualified principal residence
indebtedness.
Conclusion
These issues are complex and each loan and each situation is
different. They will require analysis by a qualified CPA or
attorney. The rules for loans that do not qualify for the
anti-deficiency statutes are much different and will result in
reportable income from the discharge of debt. Do not
automatically assume that the amount of a loan that is discharged
on a personal residence is not included as taxable income.
About the author: Beth S. Cohn is a shareholder at the Phoenix
law firm of Jaburg Wilk. She chairs the business law
department and is a State Bar of Arizona certified tax specialist
and a CPA. Beth can be reached at bsc@jaburgwilk.com or
602.248.1030.
This article is not intended to provide legal advice and
only relates to Arizona law. It does not consider the scope
of laws in states other than Arizona. Always consult an
attorney for legal advice for your particular situation.
IRS CIRCULAR 230 DISCLOSURE: To ensure compliance with
requirements imposed by the IRS, we inform you that, to the extent
this communication addresses any tax matter, it was not written to
be and may not be relied upon to (i) avoid tax-related penalties
under the Internal Revenue Code, or (ii) promote, market or
recommend to another party any transaction or matter addressed
herein.
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