How to Minimize or Eliminate Tax Liability Regarding Mortgage Debt Forgiveness
June 11, 2013
By Christopher J. Charles, Esq.
The general rule is that the forgiveness of debt is a taxable event. 26 U.S.C. § 61(a)(12). Thus, debt forgiveness is typically included within a taxpayer’s gross income. For example, if I loan my uncle $100,000 to open a new fast food franchise, and then later I hit the Powerball and subsequently tell my uncle not to worry about repaying the $100,000 loan, the I.R.S. will deem the $100,000 loan as taxable income for my uncle.
Important exceptions to the general rule, however, apply to mortgage debt forgiveness.
The 2007 Mortgage Debt Relief Act
Notably, pursuant to the 2007 Mortgage Debt Relief Act (the “Act”), the forgiveness of debt concerning a “qualified principal residence” is excluded from income tax. 26 U.S.C. §108. This essentially means that there is no tax liability on the short sale difference or foreclosure deficiency of a qualified principal residence. In order to qualify as a “qualified principal residence,” the loan must have been used to purchase or “substantially improve” a taxpayer’s principal residence. “Principal residence” is defined as the residence where a taxpayer has resided for a “period aggregating two of the last five years.” See 26 U.S.C. §121.
The Act has three major limitations: (1) it sunsets at the end of 2013; (2) it does not apply to commercial properties; and (3) it only applies to a taxpayer’s primary residence.
Fortunately, many property owners in Arizona can benefit from other exclusions under the tax code without the need to rely on the Act.
The Insolvency Exclusion
For example, if a taxpayer is “insolvent” at the time of the mortgage debt forgiveness, the taxpayer can exclude liability for the debt forgiveness (up to the amount of the insolvency), even if the property is an investment property or vacation home. 26 U.S.C. §108(a)(1)(B).
The I.R.S.’s definition of insolvency essentially means that the total sum of a taxpayer’s liabilities exceeds the total sum of the fair market value of the taxpayer’s assets, on the date immediately preceding the debt forgiveness.
The Bankruptcy Exclusion
Also, if a mortgage debt is discharged in bankruptcy, then there is no liability for the debt forgiveness, as long as the taxpayer filed the petition for bankruptcy before the debt forgiveness, e.g. before the completion of the short sale or foreclosure.
Capital Loss May Offset Any Debt Forgiveness Income Tax
Further, even if the Act does not apply, and if neither of the above exclusions apply, a taxpayer may be able to claim a capital loss regarding the disposition of the property, which may offset any debt forgiveness concerning an investment property.
Non-Recourse Debt Exception
Finally – and perhaps most importantly in Arizona – there is no tax liability for mortgage debt forgiveness regarding “non-recourse debt.” Treas. Reg. § 1.1001-2(a)(2) and (c), Ex. 8; see also Rev. Rul. 90-16, 1990-1 C.B. 12. “Non-recourse” debt means that a creditor may seize only the property that secures the loan, even if the fair market value of the property is not sufficient to cover the loan balance. “Non-recourse” debt can be the result of an express contract or the result of statute, as in the case of Arizona’s anti-deficiency statutes.
Thus, even if the Act expires and none of the above exceptions apply, a taxpayer may still have arguments to exclude tax liability for mortgage debt forgiveness, if the loan is non-recourse under Arizona law. The Arizona appellate courts have broadly interpreted Arizona’s anti-deficiency statutes and recently extended their protection to vacant land in some cases. See M & I Marshall and Ilsley Bank v. Mueller, 228 Ariz. 478, 268 P.3d 1135 (App. 2011).
Even if a loan is non-recourse, a lender will still issue the I.R.S. Form 1099-A or 1099-C regarding the mortgage debt forgiveness.
Importantly, the issuance of the 1099 is not dispositive on the issue of whether any tax is owed. Instead, a taxpayer can respond to the 1099 with the I.R.S. Form 982 to identify which of the above exceptions apply and why no tax is owed.
In sum, although the forgiveness of debt may create tax liability, taxpayers have several strategies for avoiding liability. Please visit Mr. Charles’ page at www.davismiles.com to download a free manual on mortgage debt forgiveness.
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Christopher Charles is an experienced real estate lawyer and a former “Broker Hotline Attorney” for the Arizona Association of REALTORS® (the “AAR”). He is a Partner with the law firm Davis Miles McGuire Gardner, PLLC where he serves as the chair of the Real Estate Practice Group. Mr. Charles is an Arbitrator and Mediator for the AAR regarding real estate disputes; he serves on the State Bar of Arizona’s Civil Jury Instructions Committee where he helped draft the Agency Instructions and the Residential Landlord/Tenant Eviction Jury Instructions.
Mr. Charles is a licensed real estate instructor and he teaches continuing education classes at the Arizona School of Real Estate and Business. For a list of upcoming speaking engagements, please visit www.davismiles.com. He can be reached at email@example.com.
Christopher’s company website: www.tbl-law.com