Short sales, mortgage modifications, and foreclosures all carry with them a definite possibility that the borrower will incur both unexpected tax consequences as well as other ill effects. To understand the overall impact requires a balancing of a number of different aspects of law.
In each of the above, a borrower has pledged real property as security for their promise to pay a debt. This combination of promissory note and mortgage often is referred to as the “mortgage.” Whether intentionally or not, by this incorrect, but common reference to the “mortgage” without mentioning the note, lenders often leave the impression with borrowers that the loan is forgiven when in fact it is not.
Discharge of Indebtedness
Institutional lenders are required by law to report a “bad debt” to the Internal Revenue Service. The question is in part, “When does a debt become a ‘bad’ debt?” Lenders have a lot of latitude for this determination. The fine point of definition is often left to the auditors; or, more simply stated, it is often when the lenders says it is “bad.” Lenders must match reporting the “bad” portion of the debt as a “discharge of indebtedness” for the same year in which they determine the debt is “bad,” and this is done by reporting it on Form 1099 [IRC §61(a)(12)]. Please note that even if the debtor qualifies for an exemption from income tax of this “discharge of indebtedness”, a Form 1099 must be filed by the institutional lender. It is up to the debtor to tell the IRS of his or her basis for exemption within that year’s income tax return.
Exemptions from Tax
There are three circumstances under which a debtor may avoid income tax on the discharge of indebtedness income. The first and more recently added to the Internal Revenue Code is the exemption for a discharge of indebtedness occurring in respect to the debtor’s principal residence by the end of 2012 {see IRC §108(a)(E)]. In order for a property to qualify as a principal residence, the debtor must have resided in the property as his or her home during two of the last five years [IRC §121(a)]. There is no requirement that those two years be consecutive. If you meet this qualification, the discharge of indebtedness reported on Form 1099 is not taxable. An explanation for this non-taxable treatment must accompany the tax return. So long as this imputed income arises from a qualifying principal residence, the exemption applies. This doesn’t matter whether it’s based upon a short sale, the mortgage modification with reduction of principal, or a foreclosure action. The second circumstance is that of insolvency; the third is a discharge within bankruptcy. While these do appear to be one and the same, they are quite different when viewed closely. An insolvency takes into account all assets, and all liabilities for the first test; if the end result is that you have a negative net worth, you are clearly insolvent. The second test is whether you have the present ability to meet all of your obligations. If your cash and near cash resources are insufficient to meet your obligations, then you are insolvent. Bankruptcy is in fact a specific preceding initiated within the United States Bankruptcy Court. The determination of whether you qualify for filing a bankruptcy is beyond the scope of this writing, but is somewhat similar to insolvency except that the net worth is tested after subtracting exempt assets. Suffice it to say that if you qualify for bankruptcy, then you qualify for the exemption from tax on the discharge of indebtedness income. NOTE: the indebtedness discharged must be “acquisition indebtedness” and does not apply to the extent that a mortgage exceeds $2 million.
Secondary Issues
The truth which must be carefully considered is that of all of the above tax considerations, only one prevents the lender from continuing to seek to collect from the debtor – that is a discharge of the debt in a bankruptcy. Nothing else prevents the collection of the debt even if the lender has treated the property as being released as security for the promissory note. In a short sale, the promissory note is not canceled unless it is agreed to as a separate component of the short-sale process. It is the same in a mortgage modification. In a foreclosure action, it is usual and customary for the lender to seek a judgment for the deficiency, that is, the amount by which the foreclosure sale is insufficient to pay the full debt. Even giving the lender a deed in lieu of foreclosure does not prevent a suit upon the promissory note. In Florida, actions on contracts have a statute of limitations of five years from the default under that contract. That means that if you enter into a short sale, the lender knows as of the date of closing that you have not fully paid the debt; the same is true in a mortgage modification which reduces the principal of the mortgage. The lender has a five-year window from default in which to begin an action on the debt. NOTE: the lender is not barred by the limitations period; however you can successfully defend by noting that the statute of limitations has expired.
Once a judgment has been entered for the unpaid debt (usually including fees, costs and statutory or contract rates of interest), there is an initial period of 10 years in which the debt may be collected. This may be extended by the lender near the end of the 10 years upon filing a request and paying a fee to the Clerk to extend the judgment another 10 years. Summarizing, the limitation period for suit is five years from default, but for collection once a judgment is entered, it is 10 years plus the second 10 years if renewed.
Lender abuses in respect to these collection matters are an everyday occurrence. What is not as well known is the lender abuse of delaying sending a Form 1099 until a later date. For example, suppose that the debtor lived in the house for exactly two years in 2005 and 2006. Debtor rented the house to a tenant for 2007, but lost his tenant in 2008, and hasn’t been able to rent it since. Although debtor became unable to pay the mortgage during 2008, and sold the property in a short sale, lender chose to treat the debt as “bad” in 2010. Although this was the principal residence of debtor when these events happened, he has not, as of 2010, lived in the property two out of the last five years. Debtor therefore does not qualify for the “principal residence” exemption as to the discharge of indebtedness income based on the reporting date. Debtor will probably prevail in an IRS administrative review because the events show he was treated as having a “bad” loan after a reasonable date when it should have been treated as “bad.” He will nevertheless have to incur the cost of professionals to ensure that outcome.
Lenders also often lay in wait with their judgment until they see that a debtor has now become solvent and collectible. Since the debtor still has a relationship with the lender, the lender has the right to obtain copies of credit reports and other information that may show the debtor’s collectability. Just when you thought you’re out of the woods, the lender may pop up and seize upon whatever assets it can find.
OBSERVATION: If you are going to do this, have a competent professional with a working knowledge of these issues helping you, and watching your back.