Property Foreclosure Can Become Major Headache at Tax Time
Foreclosures continue to bedevil the Southern California real estate industry, which is grappling with depressed prices and devastating damage from natural disasters ranging from fires to earthquakes to floods. And adding to the disaster for some homeowners is a taxable gain at the same time they must give up their home.
Real estate problems have led to land-office business for attorneys and realtors who specialize in so called “short-sales” and “short-pays,” which involve lenders and homeowners negotiating down the mortgage amount based on the home’s current value and the borrower’s diminished ability to pay.
In some extreme cases, banks are willing to take discounts of $100,000 or more, says Leonard Schapira, a Hermosa Beach-based real estate attorney.
At tax time, foreclosures, short-sales and short-pays create special headaches for homeowners. In cases where untaxed gains remain from earlier sales, people who have lost their homes are later saddled with federal tax bills amounting to tens of thousands of dollars.
Why? A foreclosure is considered a sale as far as the tax man is concerned. So unless you roll any forgiven “profits” into a new home within two years, the transaction is taxable.
Meanwhile, short-sales and short-pays create something called debt forgiveness income. In a nutshell, that means if you agreed to pay somebody $30,000 but paid only $20,000, the $10,000 that the lender “forgave” is income to you.
Lately, several companies, including San Diego-based Boston Harbor and Riverside-based New England Financial, have sprung up with assurances that they can save consumers on their tax bill and mitigate the negative impact on their credit reports too.
There’s just one problem. The Internal Revenue Service, the attorney general’s office and several lenders say these programs don’t work. Unfortunately, until one of these cases is taken to court, there is no definitive answer as to who is right.
What are the tax issues surrounding troubled real estate and how can homeowners mitigate them? If you sold your home for less than you paid, can you claim a capital loss? Some questions and answers.
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Q: Why is a foreclosure considered a sale?
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A: Because it’s a transfer of property--from the homeowner to the bank. And the bank “pays” for the transfer by canceling your loan. As a result, tax authorities generally consider the loan amount to be the sales price.
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Q: If the loan amount is less than what I paid for the property, how could I possibly have taxable income from the sale?
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A: It has to do with real estate rollover rules.
If you never owned property before, you would not have a taxable gain. However, if you had owned a previous home, you probably “rolled” the gain from that property’s sale into this property. The gain on the previous residence reduces your tax basis in the current home. If the tax basis is less than the selling price (or loan amount, in the case of a foreclosure), you have a taxable gain.
Consider a hypothetical individual, whom we’ll call George, who bought his first house in 1985 for $60,000. He sold the house in 1989 for $100,000 and rolled the $40,000 profit into a $150,000 home, with a $120,000 mortgage.
For tax purposes, the purchase price of the second home is just $110,000--the $150,000 purchase price minus the $40,000 rolled-over gain.
If the lender forecloses on the second home, George may think only of his apparent $30,000 loss on this house (the $150,000 he paid minus the $120,000 loan). But he has to remember that he has $40,000 profit from 1989, so his net position is a $10,000 gain.
Like any other home real estate gain, George has two years to roll it into another house. But after a foreclosure, he may be unable to get another mortgage loan that quickly. So assuming he pays tax at the 28% capital gains rate, the $10,000 profit he deferred from the 1989 sale creates a $2,800 federal tax obligation. State taxes are probably due as well.
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Q: What exactly is a short-pay?
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A: A short-pay also occurs only when the borrower is in trouble and the home’s price has fallen below the mortgage amount.
In a short-pay transaction, the lender agrees to reduce your mortgage amount based on the lower property value and your inability to pay the old loan. Lenders are not obligated, in any way, to agree to a short-pay arrangement, Schapira says. But they may agree if the borrower can show--by producing detailed financial statements--that he or she cannot pay the old loan but could and would pay if the loan amount were reduced to a level commensurate with their income.
In these situations, the borrower is able to stay in the home.
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Q: How does it affect your taxes?
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A: If your original loan was $100,000 and the lender agreed to reduce the loan amount to $95,000, you would have $5,000 in so-called cancellation of indebtedness or debt forgiveness income. That would be taxed at your ordinary income tax rates.
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Q: What about short-sales?
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A: Short-sales are generally done when the market price for the home is close to the mortgage amount, but after paying commissions and sales fees, the proceeds would be insufficient to pay off the bank loan. In that case, the bank might agree to accept the proceeds of the sale as full payment of the mortgage.
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Q: What’s the tax effect?
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A: It depends. In most instances, a short-sale will have the same tax impact as a short-pay, says Philip J. Holthouse, partner at Holthouse Carlin & Van Tright. However, some tax advisers believe the tax impact could be the same as a foreclosure sale on a first mortgage, where the lender’s only recourse against an errant borrower is to take the house.
However, if George had refinanced his home, he may have so-called “recourse” debt. With recourse debt, the bank can lay claim to George’s income and other assets to satisfy the loan. The bank may not opt to go after his income or other assets simply because doing so requires a time-consuming and unpleasant court procedure, called a judicial foreclosure.
But, because it has the right to do so, George is on the hook for cancellation of debt income for the difference between what the bank finally received from the short-sale and what it was owed on the mortgage, says Holthouse.
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Q: How can companies like Boston Harbor eliminate the tax obligation?
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A: They may be able to limit your tax loss on a short-sale, according to Eric Fagan, president of Boston Harbor. How it works is, you transfer the property to Boston Harbor. Boston Harbor issues you a Form 1099 to evidence the sale at the mortgage amount. (That triggers the same tax impact as a foreclosure.) But, if the company then negotiates a short-sale of the home for less than the mortgage amount, the company would be on the hook for the debt cancellation income, rather than you, Fagan says.
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Q: Why wouldn’t that work?
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A: There are several problems with the transaction, authorities say. First, the IRS announced in January that it considers these types of transactions “shams,” done for the sole purpose of avoiding taxes. In such cases, the IRS can unwind the deal, which means you end up with the taxable income--and you lose the 1% fee to boot. Nonetheless, the tax implications are debatable until the IRS issues a formal ruling or takes such a case to court. So far, neither has happened.
Additionally, some lenders find the practice abusive and refuse to negotiate with Boston Harbor, industry experts say. As a result, they may be harder on borrowers who attempt to transfer their properties before negotiating a short-pay or short-sale than they would have been had you tried to renegotiate the loan yourself, says Schapira.
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Q: Is there any way to mitigate the tax implications when you’re unable to pay your home mortgage?
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A: Instead of lowering the loan amount, you could ask the lender to renegotiate the interest rate or stretch your payments out over a longer period, so that your monthly cost would be more manageable. Since you’ve changed only the terms and not the loan amount, generally there’s no taxable event.
If you are insolvent--your debts exceed your assets--you are also not liable for the tax.
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Q: I may have made some money on past home sales, but I’ve also poured a lot of money into those houses. Don’t I get credit for the money I spent to maintain and fix up the home?
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A: If you made permanent improvements to the house--such as installing a pool, building a new kitchen or garage--the effective purchase price of your house is raised to reflect the amount you spent. In other words, if you spent $10,000 adding a pool at your $100,000 house, your basis in the house rises to $110,000. So, if you later sell the house for $120,000, your profit is just $10,000 rather than $20,000.
But, your basis is not adjusted for non-permanent repairs and maintenance. So, you usually can’t increase your tax basis in the house by the amount you spent on paint, wallpaper and other temporary cosmetic fixes.
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Q: Can I write off a loss on my home?
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A: No. Capital losses on residential real estate are not deductible because it is an asset owned for personal purposes, Holthouse says. Congress is now weighing proposals to make it deductible, however.
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Q: I had to make major repairs to my house because of a natural disaster, although the cost was not sufficient to claim a casualty loss. Am I able to add the cost of repairs to the basis in my house?
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A: Generally speaking, yes, says Harvey Gettleson, partner at Ernst & Young in Los Angeles. Clearly, if you had to replace walls, chimneys or fences destroyed in the quake, those expenses add to the cost of the house to create a new tax basis.
Additionally, in this isolated instance, even the cost of paint and wallpaper may be added to the basis, Gettleson says. That’s because you’re painting and spackling to cover cracks, not because you don’t like the previous color. Such expenses are necessary to replace or repair the wall, and consequently, the cost can be added to your purchase price to boost your tax basis in the home, he says.
