A tricky tax can haunt debtor after foreclosure
In a package of proposals aimed at easing foreclosure worries for homeowners having trouble making their mortgage payments, President Bush called last week on Congress to temporarily make some borrowers exempt from a little-known tax that kicks debtors when they’re down.
The provision, which assesses income tax on canceled or “forgiven” debts, can be triggered when a lender forecloses on a home or agrees to accept the proceeds of a property sale for less than the balance on the loan.
What is this tax, who is affected and what has Bush proposed? Here are some answers:
How can I possibly owe tax when I’m making no profit and losing all the equity in my home?
When you took out your mortgage, the lender gave you money, but you weren’t taxed on it because an offsetting obligation -- your debt -- was created at the same time. If part of that obligation is eliminated before you pay it off, the unpaid amount that is wiped away is considered “cancellation of debt” income.
In the case of a foreclosure, the phantom income would equal the difference between the loan balance and the fair market value of the property at the time of foreclosure. For example, if you have $500,000 outstanding on your mortgage, but your house is worth only $450,000, the Internal Revenue Service will expect you to pay tax on the $50,000 difference if the bank forecloses.
Or instead of foreclosing, the bank might let you do a “short sale” for $450,000 and accept the proceeds as payment in full for the loan. A short sale can be preferable to a foreclosure because it’s not quite as damaging to the homeowner’s credit rating, but cancellation-of-debt income is still created.
In such cases, at least under current law, be prepared to receive IRS Form 1099 from the lender in January after the sale saying you received income equal to the portion of your mortgage that you didn’t pay off, said Warren Hannagin, a certified public accountant at Glenn M. Gelman & Associates in Santa Ana.
Is the tax assessed at ordinary income tax rates?
Yes. So if you’re in the 25% tax bracket, the details in the example above would boost your federal tax bill by at least $12,500. The extra tax would be more than that if the phantom income caused you to jump a tax bracket or two.
What did the president propose?
The White House gave few details except to say it wanted a temporary change in the law so that canceled mortgage debt on a primary residence would not be counted as taxable income. Bush spoke favorably of two bills already introduced in Congress that would accomplish that goal and said he could support either one “with a few changes.” He didn’t specify the changes.
Does that mean the law will in fact be changed?
It’s hard to say. The tax is extremely unpopular, and exempting people from it is likely to have the support of many lawmakers. But tax legislation is complex and usually takes months to enact -- if it’s on a fast track. If it is passed, the law would help today’s hapless homeowners only if it was passed retroactively.
How can I avoid the tax if the law isn’t changed?
There are three common exceptions that allow property owners to escape debt-cancellation income:
“Nonrecourse” debt: If you never refinanced your home, your mortgage is probably nonrecourse debt. That means the lender has no right to anything but the value of the home, so there is no debt-cancellation income. If the home has been refinanced, however, the mortgage is generally considered “recourse” debt. That means that the lender can theoretically pursue you for the loss it incurred in foreclosing on the property. If the lender doesn’t go after you, your taxable income goes up.
Bankruptcy: Debts discharged through bankruptcy are not considered debt-cancellation income.
Insolvency: If you are insolvent when the debt is discharged and can prove it (see below), you don’t have to worry about phantom income.
Some business and farm debts, as well as foreclosures related to Hurricane Katrina, are also exempted.
How do you prove that you are insolvent?
It’s a challenge, said Philip J. Holthouse, partner at Holthouse Carlin & Van Trigt, a Santa Monica-based tax law and accounting firm. That’s because you have to add up all your debts and assets to show that you owe more than you own. And valuing personal property can be fairly complex.
If the potential debt-cancellation income is significant, Holthouse suggests hiring a tax professional to determine whether you meet the insolvency test. If the amount at stake is not significant, the professional fees will probably exceed the amount of tax you would save.
Am I subject to tax from the discharge of credit card debts or student loans?
You might be. But, as with mortgages, credit card debts discharged in bankruptcy or because of your insolvency do not create cancellation-of-debt income.
There’s also an exception for student loans that are discharged through certain federal programs, such as those aimed at helping social workers, teachers and child-care workers in economically disadvantaged areas.
What if I am subject to this tax but have no means to pay it?
The IRS has two programs that can help. So-called offers in compromise allow taxpayers to pay less than the amount of tax they owe if they are unable to pay the full amount in a reasonable period of time. The agency can also accept payment plans.
But qualifying for one of these programs can be tough. These are not for people who simply don’t want to pay; they are solely for those who can’t afford to pay. If you believe you qualify, call the agency at (800) 829-1040 or hire a seasoned tax specialist.
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Kathy M. Kristof welcomes your comments but regrets that she cannot respond to every question. Write to Personal Finance, Business Section, Los Angeles Times, 202 W. 1st St., Los Angeles, CA 90012, or e-mail kathy.kristof@latimes.com. For past Personal Finance columns, visit latimes.com/kristof.
