DEAR BENNY: I have a question relating to a forgiveness-of-debt issue. Let’s say a borrower takes out a home loan for $600,000. Later, the borrower defaults and the lender files for foreclosure. Eventually, the borrower is able to conclude a short sale for $500,000.
The borrower receives a letter from the lender stating his loan is "paid in full." Because of the letter, the borrower is under the impression that he will not receive a 1099-C from the lender showing forgiveness of the $100,000 canceled debt.
In your experience, is this true, even though the lender may have said the loan is "paid in full"? I was under the impression that lenders were obligated to send borrowers a 1099-C if the debt forgiven exceeded $600. –John
DEAR JOHN: According to law — and the Internal Revenue Service — if a financial entity cancels or forgives a debt you owe, and that debt is $600 or over, the lender is required to provide you (and the IRS) a Form 1099-C, entitled "Cancellation of Debt."
And unless you meet certain exceptions or exclusions, this canceled debt is taxable as ordinary income and must be reported on your Form 1040 when you file your annual income tax return.
There are a number of exceptions to this taxable requirement. For example, if your creditor cancels your debt as a gift, this is not considered income.
Additionally, if your student loan is canceled because you did some work after college — such as volunteering to help needy families in low-income neighborhoods — and if this is permitted under the terms of your loan, the cancellation is not income.
There are also a number of exclusions contained in the law. If your debt is included in a Chapter 11 bankruptcy case, this is not considered income to you.
If you were insolvent immediately before the cancellation — i.e., your liabilities exceed your assets — you are not required to pay any tax on the debt that was forgiven. But the burden is on you to honestly demonstrate that you are insolvent.
If the debt cancellation involved your principal residence — the home in which you live most of the year, vote and pay taxes on — and if the money you borrowed was used to buy, build or substantially improve that home, you will not have to pay any income tax on the debt that was forgiven by your lender.
This is a departure from the general rule that requires debtors to report all forgiven debt as ordinary income (Section 61(a)(12) of the Internal Revenue Code). Up until the so-called mortgage meltdown, there were only two exceptions referenced above: bankruptcy and insolvency.
However, when thousands of homes across the country began to be foreclosed upon, Congress amended the law. For debts forgiven in calendar years 2007-12, up to $2 million of forgiven debt can be excluded from the obligation to pay income tax ($1 million if married filing separately).
And according to Julian Block, a prominent tax attorney, even if you are a single taxpayer, you still can exclude the full $2 million. Furthermore, the exclusion applies to all years, and not just for one.
This is an interesting loophole in the law. If you own more than one home that is "underwater" — i.e., the mortgage exceeds the fair market value of the house — you can claim the exclusion only for your principal house.
If that house is foreclosed upon (or sold via a short sale), nothing prohibits you from moving into your second home, establishing it as your new principal residence, and so long as your total losses do not exceed the statutory cap of $2 million, you can also sell that house as a short sale (or let it go to foreclosure) and not be required to pay any income tax.
Of course, when dealing with the IRS, it seems nothing is easy. The law does not apply to all forgiven or canceled debt. So your vacation home, your car loan or your credit-card debt that is canceled will not qualify for the exclusion, unless you are insolvent or file for bankruptcy relief.
As mentioned earlier, the debt has to be used to buy, build or substantially improve your home. This is called the "qualified principal residence indebtedness" (QPRI). According to the IRS, "Debt used to refinance qualifying debt is also eligible for the exclusion, but only up to the amount of the old mortgage principal, just before the refinancing."
For additional information, you can get a good publication online from the IRS. It is entitled "Canceled Debts, Foreclosures, Repossessions, and Abandonments" (Publication 4681, available from www.irs.gov: click on forms and publications). You may also want to obtain Form 1099-C (and the instructions for completing that form, from the same website).
DEAR BENNY: What is a "contract for deed"? My real estate broker suggested that I consider this, but I don’t understand the concept. –Joe
DEAR JOE: This is also called an "installment contract" or a "land contract."
Oversimplified, you enter into a contract with a buyer for the sale of your property. The contract price, for example, is $200,000. You give the deed to the property, in recordable form, to your attorney to hold in escrow. Your buyer makes periodic payments to you. And when the buyer is able to pay you in full, you instruct your attorney to record the deed into the buyer’s name.
It was developed years ago, when the ranchers out West wanted to sell some acres to their farmhands. Because those buyers did not have enough money to pay the full price — and did not have good credit to get mortgage loans (if mortgages were even available in those days) — the rancher agreed to receive monthly payments, which were credited toward the full purchase price. When the buyer was able to pay the entire outstanding balance, he received the deed to the property.
Sounds simple, but there are many issues that have to be reviewed. For example, the Internal Revenue Service takes the position that such a transaction is considered a sale for tax purposes. That means that the seller has to determine if there will be any income tax to pay when the contract is entered into.
Also, if the seller currently has a mortgage on the property, unless that loan is paid off in full or the lender approves of the transaction, it could trigger the "due on sale" clause in the seller’s loan documents.
The due-on-sale clause is a concept that lenders created decades ago when they did not want their seller to allow a new buyer of the property to assume the existing mortgage. For example, if the current loan was 6 percent, and now the market for interest rates was much higher, the lender wanted to get the higher rate from the new buyer.
In simple terms, if you sold your property — or entered into a contract for deed — this would trigger that clause and your entire mortgage would then be due and payable.
So, you and your attorney must review your loan documents to determine if the due-on-sale clause applies. Most loan documents within the last 10-15 years will contain this concept.
Finally, in some states, the seller must record the contract on the land records in the jurisdiction where the property is located. If it is not recorded, the buyer may be entitled to a full refund of the moneys paid.
The recordation can put the lender on notice that you have entered into such a transaction, and once again can call your loan due. You should have your lawyer review the situation and advise you on the applicable laws in your state.
Benny L. Kass is a practicing attorney in Washington, D.C., and Maryland. No legal relationship is created by this column. Questions for this column can be submitted to email@example.com.
|Contact Benny Kass:|
|Letter to the Editor|