Minimizing Adverse Income Tax Consequences from Foreclosure or Short Sale
Losing property to a creditor can be painful. Paying income tax as a result of such loss adds insult to the injury. Fortunately, foreclosures and short sales do not always create income tax obligations. Even when tax is otherwise due, it is sometimes possible to reduce the tax owed through advance planning.
When is Income Recognized?
The first step in managing the income tax consequences of a foreclosure or short sale is to determine the amount and character of income which must be recognized under the regular rules. There are four variables that affect the income tax consequences:
- the current fair market value of the property;
- the amount of indebtedness;
- whether or not the debtor is personally liable for the debt; and
- the income tax basis in the property (generally, original purchase price minus prior allowable deprecation).
If the income tax basis in the property is more than the amount of the debt, no gain will be recognized upon the transfer and no tax will be due. If the income tax basis is less than the amount of the debt, the tax consequences depend upon whether the debt is recourse debt (i.e., the debtor is personally liable) or non-recourse debt (i.e., the debtor is not personally liable), and the fair market value of the property.
In the case of (1) any non-recourse debt or (2) a recourse debt which is less than or equal to the fair market value of the property, the transfer is treated as if the property was sold for the amount of the debt. Gain is recognized to the extent the debt exceeds the income tax basis in the property. The gain is taxed at the long term capital gains tax rate (currently, 15%) if a cash sale for the same amount would qualify.
In the case of recourse debt exceeding the property’s fair market value, the income tax consequences are more complicated because the taxpayer may recognize two different types of income. First, the taxpayer recognizes gain from a deemed sale to the extent the property’s fair market value is greater than its basis. Second, the taxpayer recognizes “cancellation of indebtedness” income to the extent the debt exceeds the fair market value of the property, or if the creditor forgives a portion of the debt in a short sale. For example, assume a property is transferred to a creditor in exchange for the satisfaction of a $1 million debt. The property’s fair market value is $800,000 and its basis is $500,000. In that situation, the taxpayer would recognize a $300,000 gain from the deemed sale of the property. The taxpayer would also recognize $200,000 in cancellation of indebtedness income.
The distinction between gain from a deemed sale and cancellation of indebtedness income is important because gain may be taxed as long term capital gain (subject to tax at only a 15% tax rate), whereas cancellation of indebtedness income is always ordinary taxable income (subject to tax at a rate up to 35%). Furthermore, different income tax exclusions apply to cancellation of indebtedness income and gain from a deemed sale.
Exceptions and Planning Opportunities
A taxpayer who must recognize income under the maze of rules described above may nevertheless qualify for one of several exceptions. First, cancellation of indebtedness income is not recognized to the extent the taxpayer is insolvent at the time of discharge. Second, cancellation of indebtedness income generally is not recognized if the cancellation occurs as part of a bankruptcy proceeding. This makes bankruptcy more attractive than non-bankruptcy workouts in some circumstances. Third, there is a limited cancellation of indebtedness income exception relating to debt upon a principal residence to the extent the debt was used to buy, build, or improve the residence. Presumably, gain from a deemed sale of a principal residence may qualify for the regular income exclusion that applies to taxpayers who have owned and occupied their principal residence for at least two years. Fourth, many taxpayers have net operating loss or capital loss carry-forwards accumulated from the past few years, which may absorb some or all of the income recognized. Finally, limited exclusions exist for cancellation of indebtedness income arising from certain farm and business debt.
If none of the exceptions apply, or if only a limited exception applies, a few planning options remain. Most of these options relate to changing the character of the income recognized, not the amount. While not a panacea, this type of planning depends upon the specific circumstances of the taxpayer, but can be very valuable because it saves the taxpayer twenty cents for every one dollar of income otherwise recognized.
First, it is sometimes useful for the creditor and debtor to agree upon the value of the property, keeping in mind that in some circumstances this could also affect the debtor’s exposure to a deficiency judgment. In the case of a recourse debt, it may be possible to treat more of the income recognized as long term capital gain by negotiating a higher agreed fair market value for the property. In the case of a taxpayer who is insolvent or planning bankruptcy, the incentive may be just the opposite (i.e., to negotiate a decreased fair market value for the property so as to maximize the application of the insolvency or bankruptcy exceptions to cancellation of indebtedness income recognition). Of course, the Internal Revenue Service may disagree with the value reported, even if both the creditor and debtor agree.
A second option is useful to a taxpayer who is personally liable for a debt that exceeds the fair market value of the property. In these situations, it is sometimes possible to restructure a business entity holding the property prior to the foreclosure so as to convert some or all of the ordinary cancellation of indebtedness income into long term capital gain. In the unusual situation in which the property’s fair market value is less than the debt and the debt is less than the basis, this planning may avoid income recognition altogether. This type of planning is not always possible, and should not occur on the eve of a foreclosure or short sale. Advance planning is required.