The Tax Consequences of a Mortgage Foreclosure on an Individual Taxpayers Primary Residence

Britt L. Ohlig*, University of Alabama School of Law Independent Study Research Paper, LLM in Taxation Program, Fall 2010 Introduction The year 2008 saw a sixty-three percent rise in home mortgage foreclosures, which equaled over a million.1 In 2009, over 2.8 million properties got a foreclosure notice.2 In October 2010, one in every 389 housing units in the United States received a foreclosure filing3 and it is likely that more than three million more homes will enter foreclosure in 2010.4 A high percentage of these foreclosed properties have negative equity, leaving the victims of this crisis in danger of severe and unexpected federal tax consequences.5 To the Internal Revenue Service, foreclosure is considered a taxable event and debt cancellation by a lender is viewed as taxable reportable income6. Furthermore holders of recourse loans can potentially be held personally
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Britt L. Ohlig, licensed attorney at Serenity Law Firm, www.serenitylawfirm.com. Chris Palmeri, Over one Million People Lost their Home in 2008, Bloomberg Business Week (Jan 2009), available at http://www.businessweek.com/the_thread/hotproperty/archives/2009/01/over_one_million_ people_lost_their_home_in_2008.html (last visited November 11, 2010). Lynn Adler, U.S. 2009 Foreclosures Shatter Record Despite Aid, Reuters (Jan 2010), available at http://www.reuters.com/article/idUSTRE60D0LZ20100114 (last visited November 11, 2010). National Real Estate Trends, as compiled by Realtytrac, available at http://www.realtytrac.com/trendcenter/ (last visited November 11, 2010). Sean Alfano, Foreclosures in U.S. Could Hit 1 Million as Housing Market Continues to Struggle, Report Finds, available at http://www.nydailynews.com/money/2010/07/15/2010-0715_foreclosures_in_us_could_ hit_1_million_as_housing_market_continues_to_struggle_r.html (last visited November 11, 2010). See Dan Levy, More U.S. Homeowners Have Mortgage Higher Than House Is Worth, Bloomberg (Oct 2008), available at http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aYyk2_TLjGao&refer=home (last visited November 11, 2010). Brad Cripe and Katrina Mantzke, Tax Implications of Mortgage Foreclosure, Practical Tax Strategies, 84 PRACTXST 324, 324 (June 2010).

liable for any deficiencies.7 Fortunately, many states have laws to protect troubled homeowners and the tax code includes various exclusions that can help individuals who have lost their home through foreclosure avoid burdensome taxation. Residential Real Estate Financing Many factors determine how a foreclosure takes place and these factors affect the borrowers ultimate tax consequences. Individuals that finance the purchase of a home must sign both a promissory note and a security instrument.8 The promissory note is a negotiable instrument that states the terms of the loan and the security instrument provides the property as collateral.9 The security instrument is either a mortgage or deed of trust, and state law dictates how a foreclosure can proceed depending on whether the state in which the home is located follows the title or lien theory. The borrower is referred to as the mortgagor, and the lender is referred to as the mortgagee.10 Home loans are either recourse or non-recourse, and can be acquisition debt or home equity loans. All of these concepts are further explained in the following sections. Acquisition Debt vs. Home Equity Loans Two different types of loans must be distinguished when considering tax implications on individuals that have lost their homes due to foreclosure. Acquisition indebtedness refers to initial or refinanced loans that are secured by a residence and for which the funds were obtained

Id. Irlander at 197. Id. Marianne M. Jennings, Real Estate Law 408 (8th Edition, 2007).

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in order to acquire, construct or substantially improve the same residence.11 Home equity indebtedness refers to the amount of any loans that are secured by a residence and is equal to the fair market value of the residence minus any acquisition indebtedness.12 Recourse vs. Non-recourse Loans Mortgage loans are either recourse loans, meaning that the borrower is personally liable for the debt, or non-recourse loans, secured only by the property. However, state statutes may limit collection options. In most states, mortgages are considered recourse loans,13 and upon default, the lender can first obtain a judgment against the borrower for the full amount of the loan, and if unsuccessful, foreclose on the property. 14 If the proceeds from the foreclosure sale do not satisfy the debt, the lender can then bring suit for a deficiency judgment, which is "an imposition of personal liability upon a mortgagor for an unpaid balance of a secured obligation after foreclosure of the mortgage has failed to yield the full amount of the underlying debt."15 Some states have enacted one-action statutes that allow only deficiency lawsuits, which protects the mortgagor from multiple legal actions.16 In addition, several states have gone further to enact anti-deficiency legislation, so that where inadequacy of the security results from a decline in property values during a general or local depression, the deficiency bar prevents the aggravation of the downturn that would result if defaulting purchasers lost the land and were also
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26 U.S.C. 163(h)(3)(B). 26 U.S.C. 163(h)(3)(C). Grant S. Nelson, Confronting the Mortgage Meltdown: A Brief for the Federalization of State Mortgage Foreclosure Law, 37 Pepperdine Law Review 583, 589 (2010). Id. In re Pittsburgh-Duquesne Development Co., 482 F.2d 243 (3d Cir. 1973). See, e.g., Cal. Civ. Proc. Code 726; Idaho Code 6-101; Nev. Rev. Stat. 40.430.

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burdened with personal liability.17 These types of laws make mortgage loans non-recourse as a matter of law. However, in some jurisdictions only acquisition debt is considered non-recourse, leaving the borrower responsible for home equity debt.18 Mortgage Law Theories In the United States there are three different theories of mortgage law; the title theory, the lien theory, and a combination of the two known as the intermediate theory. The title theory is based on the common law, and in states that follow this theory, the mortgagee retains title to the property until the loan is paid in full or the property is foreclosed.19 In such jurisdictions, a deed of trust is commonly used as the security instrument. A deed of trust normally conveys the property to a third person in trust, who holds it as security.20 These instruments nearly always contain a reconveyance clause that transfers the property to the mortgagor upon full payment of the promissory note21 and a power of sale clause that allow the trustee to foreclose the property after a default and upon the request of the lender.22 In states that follow the lien theory, a mortgage is usually the security instrument. The mortgage creates a lien against the property that the lender records, and legal title is held by the

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Cornelison v. Kornbluth (1975) 15 Cal.3d 590, 601. List of Non-Recourse Mortgage States and Anti-Deficiency Statutes, available at http://www.helocbasics.com/ list-of-non-recourse-mortgage-states-and-anti-deficiency-statutes/ (last visited November 11, 2010). Dale A. Whitman, The title, lien, and intermediate theories of mortgage law, 1 Real Estate Finance Law 1.5 (5th Edition, 2010). Whitman, supra note 19 at 1.6. Sam Irlander, Florida Real Estate: Principles, Practices and License Laws 195 (2008). Whitman, supra note 20.

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mortgagor,23 who has the right to possession of the property until foreclosure.24 Under the intermediate theory, the mortgagor has the right to possession until default, and then it passes to the mortgagee.25 Types of Foreclosure There are two general types of foreclosures in the United States, strict foreclosure and public sale of the premises, with public sales being either judicial or non-judicial.26 Judicial foreclosures are allowed in every state; they begin with the lender filing a lawsuit against the borrower and end with the sale of the foreclosed property under the supervision of a court.27 With judicial foreclosure, the lender obtains possession of the property and any equity in the property is liquidated.28 Nine steps are required to complete a judicial foreclosure: the lender invokes the acceleration clause which results in the entire balance being due, a title search is performed on the property, a notice of lis pendens is filed to inform the public about the pending action, the lender files a lawsuit against the borrower and upon winning, sells the property by public auction, the court clerk files a certificate of sale with court approval, the lender is paid from the proceeds, the buyer receives title, and any leftover funds are used to pay outstanding liens with the remainder going to the borrower.29
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Irlander, supra note 21. Whitman, supra note 19. Id. Whitman, supra note 19 at at 1.4. Irlander, supra note 21. Irlander at 203. Id.

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Non-judicial foreclosures rely on state statutes. Upon default, the lender must follow the strict state requirements including mailing a default letter and in some jurisdictions, recording a Notice of Default. Uncured defaults result in the lender posting a Notice of Sale in public and in legal publications, followed by a public auction that generally requires cash or a cash equivalent at the sale.30 Strict foreclosures are limited in use and usually proceed through the court system.31 Upon default, the mortgagor is given a period of time to pay the mortgage debt and if unable to do so, the property vests in the mortgagee without a foreclosure sale. Gain or Loss from Foreclosure Real estate is considered a capital asset.32 The tax code treats a foreclosure as a sale or disposition and requires the calculation of capital gain or loss33. Gain is the amount realized minus the adjusted basis, and loss is the adjusted basis minus the amount realized.34 For individuals who have non-recourse loans, the amount realized is the balance of the mortgage loan, and for individuals with recourse loans, the amount realized is the fair market value of the home at the time of the foreclosure sale.35 The fair market value of the property is

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Id. Whitman, supra note 19 at at 7.9. 26 U.S.C. 1221(a). 26 U.S.C. 1001(a). Id. 26 CFR 1.1001-2(a).

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presumed to be the foreclosure sale price, in the absence of clear and convincing proof to the contrary.36 Taxation of Capital Gain or Loss For individuals, capital gain must generally be added to gross income. However, the tax code offers an exclusion for gain from the sale of a principal residence.37 This exclusion applies if the property was owned and used by the taxpayer as a principle residence for a total of two years within the previous five years.38 This exclusion is limited to one sale every two years and is capped at $250,000 for single taxpayers and $500,000 for most spouses filing joint returns.39 For individuals, capital loss can be offset against capital gain. If the loss exceeds the gain, the tax code allows a deduction of up to $3,000 for a single taxpayer, and $1,500 for spouses filing individual returns. However, the tax code does not allow any deduction for a capital loss upon the sale of a personal residence.40 Determining the Adjusted Basis of Property The adjusted basis of property is the basis, adjusted by certain criteria.41 The basis is calculated by determining the cost of the property, which is the amount paid in cash or other property and includes debt obligations including assumption of a mortgage.42 Cost basis also
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26 CFR 1.166-6(b)(2). 26 U.S.C. 121(a). 26 U.S.C. 121(b). Id. 26 U.S.C. 165(c). 26 U.S.C. 1011. 26 CFR 1.1012-1.

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includes costs such as settlement fees, closing costs, abstract of title fees, charges for installing utility services, legal fees for title search and preparation of the sales contract and deed, surveys, transfer taxes, title insurance, recording fees, interest, mortgage fees, improvements or repairs, and sales commissions.43 Adjusted basis is calculated by making adjustments to the cost basis for expenditures, receipts, losses, or other items such as improvements, zoning costs, legal fees to defend or perfect title to the property, casualty or theft loss.44 Cancellation of Debt Income Funds that an individual receives for an acquisition or home equity loan is not considered gross income because it must be repaid. 45 However, debt that is discharged by a lender is considered gross income and thereby taxable.46 For homeowners that lose their homes in foreclosure due to major financial setbacks, such as the loss of a job or high medical bills, this result can be very burdensome. Fortunately for many of these individuals, it may be possible to exclude this amount from gross income under the insolvency exclusion or the qualified principal residence exclusion. If an individual qualifies for both the insolvency exclusion and the principal residence exclusion, the tax code specifies that the latter takes unless elected otherwise.47 Insolvency Exclusion from Cancellation of Debt Income

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26 CFR 1.263(a)-2. 26 U.S.C. 1016. 26 U.S.C. 61(a)(12). Id. 26 U.S.C. 108(a)(2).

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The tax code allows an exclusion for cancellation of debt income if the discharge occurs when the taxpayer is insolvent.48 A taxpayer is considered insolvent when total liabilities are higher than the fair market value of all assets immediately before the debt is discharged.49 Some limits are placed on this exclusion. For example, the amount that can be excluded is limited to the amount by which the taxpayer is insolvent.50 Also, the amount excluded from gross income reduces tax benefits to which the individual would normally be entitled, such as the minimum tax credit, any capital loss carryovers, basis reduction of property and foreign tax credit carryovers.51 Qualified Principal Residence Exclusion from Cancellation of Debt Income The Mortgage Forgiveness Debt Relief Act of 200752 amended the tax code by adding an exclusion from gross income any discharge of indebtedness income of a qualified principal residence during the years 2007- 2009.53 This exclusion was extended to 2012 by the Emergency Economic Stabilization Act of 200854. If the forgiven debt is excluded from income, the amount must still be reported, and any amount excluded must be applied to reduce the basis of the taxpayers principal residence. However, in the case of foreclosure the reduction of basis does not apply because the taxpayer no longer has any interest in the property. To qualify for this exclusion, the cancelled debt must have been acquisition indebtedness for the principal residence

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26 U.S.C. 108(a)(1)(B). 26 U.S.C. (d)(3). 26 U.S.C. (a)(3). 26 U.S.C. (b). P.L. 110-142 2(a). 26 U.S.C. 108(a)(1)(E). P.L. 110-343, Div. a, 303(a).

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of the taxpayer.55 The maximum amount that can be excluded is two million dollars for single taxpayers, and one million dollars for spouses filing separately.56 Example Calculation For the sake of illustration, suppose that Ms. Smith buys a home in 1998 for $170,000 and during the ten years that she lives in the residence makes $30,000 worth of improvements. Her adjusted basis in the home is then $200,000. After her home increases in value, she refinances it for $425,000. Unable to make payments after she loses her job, Ms. Smith loses the home to foreclosure in 2008 and the bank sells it for the fair market value of $250,000. If Ms. Smith has a non-recourse loan, the amount realized is the amount she owes, $425,000 minus the adjusted basis in the property of $200,000. She has a gain of $225,000. Since she qualifies for the exclusion for gain from the sale of a principal residence, any gain up to $250,000 is excluded and she does not need to pay taxes on this amount. If Ms. Smith has a recourse loan, the amount realized is the fair market value of $250,000 minus the adjusted basis in the property of $200,000. She has a gain of $50,000. Since she qualifies for the exclusion for gain from the sale of a principal residence, any gain up to $250,000 is excluded and she does not need to pay taxes on this amount. However, if by statute Ms. Smith is not responsible for paying the $175,000 deficiency, or if the lender forgives the debt, the discharge of indebtedness is generally taxable. Since Ms. Smiths loan was acquisition indebtedness and the foreclosure happened in 2008, the qualified principal residence exclusion applies, which allows her to exclude the discharge of indebtedness income. Conclusion
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26 U.S.C. 108(h)(2). Id.

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The taxation of foreclosure is highly complex and involves layers of state and federal statutes and regulations. Many factors must be taken into account when considering tax consequences, including the type of loan, the number of years the taxpayer lived in the home, the type of debt and whether the taxpayer is solvent. Some exclusions, such as the insolvency exclusion, have been available to taxpayers for a number of years, to help them avoid high taxation after foreclosure. However, the recent foreclosure crisis has impacted a high percentage of Americans and Congress reacted by passing legislation that assists taxpayers in avoiding further financial burdens, such as the qualified principal residence exclusion. So far this legislation only applies to foreclosures through 2012. Whether the legislation will be extended remains to be seen.