Foreclosures and Short Sales
Many of my clients have lost rental properties to foreclosure, and a few have lost their homes. And to make things worse, the foreclosure may be taxable!
The IRS has released guidance saying that in general reductions of principal under HAMP will not be taxable income.
You should receive either a Form 1099-A or a Form 1099-C from the bank. (In many cases where the banks have gone out of business, no forms are issued.) The forms should show what the bank estimated the property was worth when it foreclosed. It should also show the balance of the mortgage. It is important that you check those figures with your tax accountant. The bank may have guessed very low regarding the property's value. And it may have included accrued interest in the mortgage balance, which is incorrect.
The difference between the unpaid mortgage and the value of the property is "cancellation of debt" (COD) and it's generally taxable income.
Both the IRS and FTB are now taking the position that COD income related to a short sale of a principal residence which still has its original mortgage in California will not be subject to personal income tax. (This is because the homeowner cannot be held personally liable for the difference between the original loan and the amount of the short sale pursuant to Cal. Code of Civ. Proc. Section 580e.) Instead, the amount of debt forgiven is included in the amount realized in determining gain on the sale of the property.
One positive note is that the loss of a rental property is treated as a sale. So you will report a loss equal to the value at the time the bank takes it, minus what you paid for it, plus depreciation. Also, if you have unused rental losses from prior years, those are freed up in the year of foreclosure. For many rental property owners, these two items can substantially offset the cancellation of debt income, or even create a tax loss!
In addition, your cancellation of debt may not be taxable if, on the day before the bank took the property, your total assets were less than your total debts. This is called the "insolvency exception." It is available for both federal and California taxes.
All of the above are just the most common factors to consider, but there are many other exceptions (including bankruptcy) and details not included here. So if it looks like a foreclosure / short sale is in your future, I strongly recommend that you talk with an experienced tax accountant right away.
Bess Kane, CPA