Tax Consequences of the Foreclosure Process
This chapter provides a general overview of the federal income tax consequences to the taxpayer who receives an IRS Form 1099-A or 1099-C from the mortgagee because the taxpayer’s property was foreclosed or all or part of the taxpayer’s debt was canceled by the mortgagee’s forbearance agreement with the taxpayer. These forms are reproduced at forms 15-1 and 23-1 in this manual. For income tax purposes, the foreclosure or cancellation of a debt by the mortgagee is generally considered ordinary income because gross income means “all income from whatever source derived, including…income from discharge of indebtedness,” and there is no distinction between voluntary and involuntary dispositions of property by the Internal Revenue Service. See 26 U.S.C. § 61(a)(3), (12).
Because of the complexity of the income tax rules and the uncertainty of what law will be in effect in the future, a taxpayer is advised to consult with an experienced tax attorney, certified public accountant, or enrolled IRS agent (see Treasury Department Circular 230) when preparing a taxpayer’s tax return after receiving IRS Form 1099-A or 1099-C from the taxpayer’s lender.
§ 23.2Foreclosure Is a Taxable Event
The IRS treats a foreclosure as a taxable sale or exchange that requires a determination of whether the foreclosure sale resulted in income to the taxpayer obligated for the debt based on whether there was a taxable gain or loss to the taxpayer obligated for the underlying debt. A recognized gain must be included in gross income and a recognized loss is deductible from gross income. To calculate ordinary income from a foreclosure sale, see Part 1 of Table 1-2, Worksheet for Foreclosures and Repossessions, in IRS Publication 544, “Sales and Other Dispositions of Assets,” available online at https://www.irs.gov/publications/. To calculate the loss or gain from a foreclosure sale, see Part 2 of Table 1-2. To determine the adjusted basis of the property used in the Table 1-2 calculations, see IRS Publication 551, “Basis of Assets,” available online at https://www.irs.gov/publications/. A gain occurs when the foreclosure sales price exceeds the taxpayer’s adjusted basis in the property and a loss occurs when the adjusted basis is more than the foreclosure sale price. If the loan balance was more than the fair market value of the property at the time of the foreclosure sale, the difference is treated as income to the taxpayer for tax purposes.
§ 23.3Determining Gain or Loss and Income
If a taxpayer is personally liable for the debt, the gain or loss of income resulting from the foreclosure sale is based on (1) the outstanding debt immediately before the sale, reduced by any amount that remains a personal liability of the mortgagor immediately after the sale (i.e., the deficiency as determined under Texas Property Code sections 51.003 and 51.004), and (2) the fair market value of the foreclosed property at the time of sale.
However, if the fair market value of the foreclosed property that was used as the taxpayer’s principal residence is less than the amount owed on the debt secured by the property, the difference is treated as ordinary income to the taxpayer. However, if the foreclosure sale resulted in a capital loss, the taxpayer cannot deduct the loss from the taxpayer’s return for income tax purposes. See IRS Publication 544, “Sales and Other Dispositions of Assets,” available at https://www.irs.gov/publications/.
The IRS simplifies the task of calculating gain or loss and income by providing Table 1-2, Worksheet for Foreclosures and Repossessions, in IRS Publication 544, which is a simple, fill-in-the-blank form using the information received by the taxpayer on IRS Form 1099-A or 1099-C.
§ 23.4IRS Forms 1099-A and 1099-C
The best source of information concerning the nuances of Forms 1099-A and 1099-C is the IRS Instructions for Forms 1099-A and 1099-C, which is reproduced as form 23-2 in this manual.
The taxpayer’s lender is responsible for providing a taxpayer with IRS Form 1099-A or 1099-C. The lender must send one of these forms to the taxpayer after a foreclosure sale if the lender made a loan to the taxpayer in connection with the lender’s trade or business and acquired an interest in the taxpayer’s property that secured the taxpayer’s debt in full or in part.
Form 1099-A contains the date the lender acquired the secured property, which is the earlier of the date title was transferred to the lender or the date the lender obtained possession of the property. See form 15-1. In addition, Form 1099-A contains the balance of the taxpayer’s debt that was outstanding at the time the lender acquired the secured property. This amount includes the unpaid principal but not accrued interest or foreclosure costs. The fair market value of the foreclosed property is also included on Form 1099-A, which for tax purposes is the gross foreclosure sales price. If the property was conveyed to the lender voluntarily, such as by a deed in lieu of foreclosure, the fair market value for tax purposes is the property’s appraised value. Whether the taxpayer was personally liable for the debt and whether the debt was modified is also noted on Form 1099-A.
Any financial institution, credit union, federal government agency, or entity that is in the business of lending money that cancels or forgives more than $600 of a taxpayer’s debt, must provide IRS Form 1099-C to the taxpayer upon foreclosure. See form 23-1. Form 1099-C is used only for cancellation of a debt the taxpayer actually incurred and not if the debt was canceled due to identity theft. Form 1099-C must be provided to the taxpayer even if the taxpayer will not be required to report any income for tax purposes because of the foreclosure sale.
The debt reported on Form 1099-C is the stated principal, stated interest, fees, penalties, administrative costs, and fines. A debt is considered canceled due to foreclosure when the lender is barred by law, including local law, from pursuing additional debt collection efforts against the taxpayer. A guarantor or surety is not considered a debtor for the purposes of a Form 1099-C.
The amount considered discharged on Form 1099-C does not include any amount the lender received in satisfaction of the debt by means of a settlement agreement. As in Form 1099-A, the lender must report in Form 1099-C whether the taxpayer was personally liable for the debt. The fair market value of the foreclosed property for Form 1099-C purposes is the purchase price received at the foreclosure sale.
If the taxpayer receives a Form 1099-A or Form 1099-C from the lender, it means the lender filed a report with the IRS regarding the underlying debt. If two or more taxpayers are jointly or severally liable for the debt, all taxpayers will receive a Form 1099-C showing the entire amount of the canceled debt that is considered income. The amount of income each taxpayer must realize, however, depends on state law, the amount of the debt each person received, the interest amount deduction claimed by each person, the basis of the co-owned property, and if the canceled debt qualifies for an exception or exclusion. See IRS Publication 4681, “Cancelled Debts, Foreclosure, Repossessions, and Abandonments,” available at https://www.irs.gov/publications/.
§ 23.5Reductions of Tax Attributes
If a foreclosure sale results in income to the taxpayer, the taxpayer must report the income on IRS Form 982 and attach it to the taxpayer’s income tax return. This form and its instructions are reproduced at forms 23-3 and 23-4 in this manual. Part I of the form requires the amount the taxpayer claims should be excluded for income tax purposes and why the income received from foreclosure should be excluded. If income is attributed to a “qualified principal residence” debt, income reported on IRS Form 982 will be excluded from the taxpayer’s Form 1040.
Part II of Form 982 is used to reduce the taxpayer’s basis in the taxpayer’s “qualified principal residence” if income is being excluded from the taxpayer’s return. “Qualified principal residence” is discussed in the following section. IRS Publication 523, which includes worksheets on how to determine the adjusted basis for a taxpayer’s main home, is user-friendly and written in plain English.
§ 23.6Qualified Principal Residence Indebtedness
“Qualified principal residence indebtedness” is any mortgage used to buy, build, or substantially improve the taxpayer’s principal residence or to refinance the mortgage, but only up to the amount of unpaid principal at the time of the refinance. The qualified principal residence indebtedness exclusion does not apply if the debt was canceled in a Chapter 11 bankruptcy. See IRS Publication 4681 for information related to a taxpayer’s principal residence.
The IRS has initiated a program manned by volunteers who provide income tax assistance and tax counseling for the elderly and free tax return preparation to certain qualified individuals with low to moderate income. To obtain this assistance, the taxpayer can contact the IRS at (800) 829-1040 or AARP Tax Aide at (888) 227-7669.
Almost all questions related to the tax consequences of a foreclosure sale can be obtained from the IRS website at https://www.irs.gov/; IRS Publications 544 and 4681; and the instructions for Forms 982, 1099-A, and 1099-C.