Recent media reports have noted an anticipated wave of foreclosures on homeowners who are unable to make payments associated with some adjustable rate mortgage products. In addition, some markets have experienced more than one quarter of declining home prices. Those news reports have not mentioned the tax problem that sellers in short sales and foreclosures will face if lenders forgive (i.e., do not require payment on) some or all of a mortgage debt at the time of disposition. We have begun to receive questions about this problem and are taking action to correct it.
For example: Assume a family purchased their home for $200,000, with a mortgage of $195,000. Later, they need to sell the home, and find that the value of homes in their area has declined, and they can sell for only $185,000. At the time of the sale, the outstanding balance on the mortgage might be, for example, $190,000. Thus, there will not be enough cash at settlement to repay the lender the full balance of the mortgage. In some circumstances, a lender might forgive the amount of any shortfall ($5,000 in this example).
In this example, the seller will be required to recognize $5000 of income (the forgiven amount of the debt) and pay tax on it at ordinary rates. Thus, the seller, who has experienced a true economic loss, is required to pay tax on any phantom income, even though no cash has changed hands and even though he has experienced a loss. Similar results would apply in a foreclosure where some debt amount remains outstanding at the conclusion of the proceeding.
Any lender who forgives debt is required to provide a Form 1099 information report to the borrower and to the IRS stating the amount of the forgiven debt. The Form 1099 will be required in any circumstance when a debt is forgiven, whether it is a short sale, foreclosure, deed in lieu of foreclosure or any similar arrangement that relieves the borrower of the obligation to pay some portion of a debt.
What is NAR doing about this problem?: NAR adopted policy seeking a correction of this problem in the mid-1990s. In 1999 and 2000, two different bills passed the House and Senate including a provision that made any debt forgiveness on a sale of a principal residence non-taxable. Unfortunately, the bills that included this relief were never enacted. During the 2001 – 2005 housing boom, the issue faded from the congressional tax-writing committees’ agendas.
NAR has identified sponsors for a new bill that would assure that any debt forgiven on disposition of a principal residence will not be taxed. That bill should be introduced shortly before or after the Easter break. When it is introduced, NAR plans to make an aggressive push to secure enactment.
What can you do? We are bringing this problem to your attention so that you can alert your members to this tax problem. In addition, we will be seeking “stories” about the experiences in your marketplace that illustrate the terrible problems individuals will face when they find themselves in foreclosure or in short sales circumstances. |
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