The current real estate market may have some unpleasant surprises for borrowers who lose their property due to abandonment, foreclosure or need to utilize a short sale.

When a lender forecloses on real estate, the IRS requires the borrower to treat the event as a sale of the property and possibly recognize gain or loss. A recognized gain may be taxed to the borrower either as capital gain or ordinary income. Generally the portion related to cancellation of indebtedness is treated as ordinary income to the borrower.

In cases where the borrower is not personally liable for the loan such as a non-recourse loan or a purchase money loan(s) and there is a gain, the borrower will receive preferential capital gain treatment on the foreclosure.
In California acquisition debt is typically the amount of debt a debtor borrowed to purchase the property and is considered a non-recourse loan.

If the borrower is personally liable for the loan, as in a refinanced loan or a loan that was not an acquisition loan, then a gain on the foreclosure could contain a combination of capital gain and ordinary income. The capital gain portion would be he difference between the taxpayers “Basis” and the fair market value of the property immediately prior to the foreclosure. The ordinary income portion which represents debt cancellation is the excess of the principal loan balance over the fair market value of the property immediately prior to the foreclosure.

Tax on the cancellation of debt will not be owed by the borrower if the debt is discharged in bankruptcy, the borrower is insolvent, the fair market value of the property is greater than the canceled debt, or the canceled debt is treated as a gift by the lender. The IRS has said that it will not allow any canceled debt by a commercial lender as a gift.

Congress is considering legislation which will not tax a borrower on the forgiveness of acquisition debt (purchase money loans) in a foreclosure or short sale on real estate that is used as a primary residence. This bill is now being considered by the senate.

Unfortunately the circumstances of foreclosures and short sales usually are under duress and not something a borrower wants to initiate. It is difficult to deal with the stress involved and the aftermath of possible consequences with the IRS. Obviously in most situations if it involves recourse loans a short sale would be more beneficial to both the borrower and the lender and have a lesser financial tax impact than a complete foreclosure.

IF one finds themselves in such a situation it is highly recommended that they seek appropriate legal advice from professionals. The advice may not be what you want to hear but ignorance does not keep the tax man away. David Dunner, CPA for Guardant Investments, is our source for legal advice and opinions in this article. David may be reached from the affiliate page of our executive team on our web site.

Keith Webb
CEO