This article examines the income and profit reporting for the seller-in-foreclosure when the price paid by the buyer is less than the balance due on loans encumbering the property and the loans are paid off at a discount.
The discount: is it profit or income?
An owner whose residence is now in foreclosure purchased it for the price of $450,000, with a down payment of $50,000. The remaining $400,000 of the purchase price was funded by a fixed-rate, purchase-assist loan covered by default insurance, called private mortgage insurance (PMI).
The homeowner’s cost basis in the residence is the $450,000 price he paid, plus transactional costs he incurred on the acquisition. His cost basis will be subtracted from the net sales price he receives for the property, called the price realized. The result is the profit or loss he will report on a resale of the residence or disposition by foreclosure or a deed- in- lieu.
The residence was purchased at the peak of the previous real estate boom. Due to the cyclical decline in real estate values since then, the owner’s residence is now worth $300,000. However, while the monthly mortgage payments have remained the same, the owner’s household income has declined. All of the household’s disposable income is now consumed by payments on the loan. Thus, the owner can no longer afford to make those payments.
Editor’s note — The same impact on a household’s disposable income occurs for those homeowners who experience an increase in the dollar amount of monthly installments on the resetting of payments for a negative amortization ARM loan, euphemistically called a subprime loan, while at the same time their pay raises are normal and far less annual increases.
The loan balance is now $389,608.88, an amount far in excess of the current market value of the property.
The owner lists the residence with a broker in an attempt to sell it and get out from under the excess debt. As agreed with the broker, any purchase agreement entered into will be subject to the lender’s approval and acceptance of the net sales proceeds as the payoff amount.
The broker taking the listing understands that because the fair market value of the residence is below the outstanding debt encumbering it, he must, as additional effort required to sell the property, negotiate with the lender for a discount on a loan payoff demand, called a short payoff. If the lender agrees to accept a short payoff by discounting the amount due, the property will have gone through what has become called a “short sale”.
The income tax issue confronting the seller when reporting the sale to the IRS and the FTB is whether:
- the discount is added to the sales price paid by the buyer (a sum equaling the loan amount) to arrive at the price realized on the sale, which usually results in a capital loss after deducting his cost basis; or
- the discount is subtracted from the seller’s cost basis, either reducing his capital loss or creating a taxable profit; or
- the discount is reported by the seller as discharge-of- indebtedness income, limiting the price realized to the price paid by the buyer from which his cost basis is deducted, resulting in a capital loss.
The short sale and discount
A short sale is a sale of property that:
- generates net proceeds in an amount less than the principal balance owed on the loan of record; and
- the lender accepts the seller’s net proceeds from the sale in full satisfaction of the loan.
The difference between the principal balance on the loan and the lesser amount of the net sale proceeds accepted by the lender in full payoff of the loan is called a discount, an arrangement more commonly called a short payoff.
If the broker is initially unable to negotiate a short pay (discount) with the lender, the seller will make no further payments, if he has not already ceased doing so. Thus, the lender is forced to foreclose if it fails to arrange a compromise called a pre- foreclosure workout. Some lenders require the seller to default on payments for three months before they will consider a discount and accommodate a short sale. A default is the first step in an owner’s exercise of the “put option” he holds, a right inherent in all trust deed loans that allows the owner to force the lender to buy the property through the foreclosure process.
The broker’s ability to successfully negotiate a short payoff with the lender depends in part on the type of loan that encumbers the seller’s property.
If the loan is an FHA-insured loan on an owner-occupied, single family residence, the lender may only accept a short payoff if the owner qualifies for FHA pre-foreclosure sale treatment. To qualify, the homeowner must be in default on at least three months’ payments, in addition to other financial ability requirements. [HUD Mortgagee Letter 94-45]
Likewise, if the loan is a conventional loan covered by private mortgage insurance (PMI), the lender’s willingness to negotiate a short pay will be influenced by the lender’s ability to settle their claim with the private mortgage insurer to cover the lender’s loss on the short payoff. Much documentation on the seller’s solvency and the property’s value must be produced and analyzed by the lender.
Discount on refinancing is profit
Now consider an owner who originally purchases his principal residence with a fixed-rate purchase assist (nonrecourse) loan of $150,000. The owner later refinances his home for $450,000, but the funds in excess of the original loan are not used to improve the property. Thus, the owner’s cost basis remains $150,000.
By refinancing, the owner encumbers his property with a trust deed loan that did not assist in the purchase of his principal residence. Thus, the refinanced loan is a recourse debt that carries with it different tax consequences than the owner’s original nonrecourse loan.
Editor’s note — Equity loans and refinancing are always recourse loans since the net proceeds do not themselves finance the owner’s purchase or improvement of the one-to-four unit residence that, in whole or in part, he occupies as his principal residence. [Calif. Code of Civil Procedure §580(b)]
Due to a decline in property values, the home is now worth $350,000, far less than the $425,000 of remaining principal on the recourse loan. Further, the owner is no longer able to afford his monthly mortgage payments.
The owner hires a listing agent who negotiates a short payoff with the lender, and the property is sold for $350,000, creating a discount of $75,000.
Unlike nonrecourse loans, the discount on the recourse debt is not added to the sale price to create a price realized equal to the loan’s principal balance. Instead, the discount is subtracted from the owner’s cost basis of $150,000, creating an adjusted cost basis of $75,000. Thus, the owner’s capital gain is $275,000 — the sales price minus the owner’s cost basis.
Here, the owner’s capital gain is a taxable profit. However, the owner’s plight is mitigated by the fact that he qualifies to be excluded from paying taxes on $250,000 of the $275,000 reported profit since he has resided on the property for at least two of the last five years. The remaining $25,000 is taxable, but at a lower rate than had the discount been reported as income. [Internal Revenue Code §121]
Editor’s note — Had the property been sold before January 1, 2007, the entire amount of the discount ($75,000) on the recourse loan would have been reported as income and taxed at a rate of up to 35%.
Recourse loans taxed as income after 2009
The preferential tax reporting as a capital gain or loss currently available for a discounted payoff of both nonrecourse and recourse loans will not be allowed on short sales of real estate involving recourse loans after December 31, 2009. The discount on a recourse loan will no longer be subtracted from the owner’s cost basis, but instead reported as gross income, as it had been before January 1, 2007. Thus, the owner will not even be entitled to the 15% (capital gain) to 25% (recapture of depreciation gains) tax rate on profit. Instead, he will be taxed on the full discount at ordinary income rates (17% to 35% in 2007).
When a short sale occurs after December 31, 2009 on real estate encumbered by a recourse loan, the seller will incur a tax liability at ordinary income rates on the discount, which is labelled discharge-of- indebtedness income. Conversely, when a nonrecourse debt is discounted on a short sale, the seller’s tax liability, if any, will still be on any profit taken on the price realized. That price realized will remain set as the principal amount of the nonrecourse loan, without concern for the discount or the property’s fair market value.
For example, an owner’s property is encumbered by a $400,000 trust deed loan. The loan is a recourse debt that exposes the owner to a deficiency judgment if the value of the secured real estate becomes less than the amount of the debt. The real estate is now worth only $300,000, $100,000 less than the loan amount, which is the deficiency. However, the owner’s cost basis in the real estate is $450,000.
The owner sells the real estate on a short sale. The net amount the buyer pays for the real estate is $300,000. The lender accepts the net proceeds from the sale as a short payoff and in full satisfaction of the recourse note. The remaining unpaid balance of $100,000, the discount, is forgiven by cancellation of the note since the lender does not judicially foreclose as is first required to pursue a deficiency judgment against the borrower.
The owner’s tax consequences, calculated based on both the sale of the property and the discount of the recourse loan, include:
- a capital loss of $150,000 ($300,000 price received from the buyer minus the $450,000 owner’s cost basis); and
- discharge-of-indebtedness income of $100,000 ($400,000 loan amount minus $300,000 price realized and paid to the lender), reported as ordinary income.
Again, since the owner’s cost basis is greater than the sales price on the sale of the owner’s personal residence, the resulting capital loss is a personal loss. Since it is not a loss on property that falls within an income category due to its personal nature, it cannot be written off to offset the taxation of other income — specifically the discharge of indebtedness income.
Thus, after December 31, 2009, a discount on the payoff of a recourse loan encumbering a personal residence will result in taxable discharge-of-indebtedness income. Ironically, this income produced by the short sale of the personal residence cannot be offset by the capital loss produced by the same personal residence on the sale. The loss is classified as personal. [Vukasovich v. Commissioner of Internal Revenue (9th Cir. 1986) 790 F2d 1409; Internal Revenue Code §165(c)]
Foreclosure on a recourse loan
Whether real estate encumbered by a recourse loan is lost to the lender in a foreclosure sale or sold to a buyer under a purchase agreement, the owner has disposed of the property. Thus, both situations should produce the same tax consequences; however, they often do not due to the lender’s bid at the foreclosure sale and their filing of a 1099 form with the IRS.
Consider a judicial foreclosure sale of real estate encumbered by a recourse loan. The lender seeks a deficiency judgment on completion of the sale since the proceeds from the judicial foreclosure sale are insufficient to satisfy the outstanding principal balance on the loan.
The owner reports the amount of proceeds from the judicial sale (plus the amount of any liens with priority) as the price realized on his loss of the property through foreclosure. [Aizawa v. Commissioner of Internal Revenue (1992) 99 TC 197]
To calculate his profit or loss from the foreclosure sale, the owner subtracts his cost basis from the price realized, which is the high bid at the sale since the loan is recourse in nature. [Rev. Regs. §§1.1001-2(a)(2), 1.1001-2(a)(4)(ii), 1.1001-2(c) Example 8]
As long as the deficiency judgment remains unpaid, the owner will not incur any tax liability for discharge-of-indebtedness that is represented by the amount of the judgment. However, if the lender later cancels the deficiency judgment or allows it to expire (ten years), discount consequences apply.
If the lender cancels the deficiency judgment before December 31, 2009, then the discount is simply subtracted from the owner’s cost basis, creating either a reduced capital loss or an increased profit that is taxed at lower capital and recapture gains rates, not personal income rates — or often excluded in part or altogether.
However, if the lender cancels the deficiency judgment after December 31, 2009, or allows it to expire in ten years, the owner must then report the amount unpaid on the deficiency judgment as discharge-of-indebtedness income.
An alternative of great importance to a seller faced with discharge of indebtedness income is to avoid a short sale and thus a short payoff by forcing the lender to foreclosure. Lenders nearly always foreclose by a trustees sale and then bid in the property at the amount of all monies owed them, regardless of its present value. Thus, they have been fully satisfied without a discount or uncollectible amount remaining due.
Listing brokers should take note, since they are duty bound to care for and protect their client seller.