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Acquisition or Abandonment of Secured Property, or, Cancellation of Debt, or both. Depending on the circumstances, you may have to report either gain on the sale of property, cancellation of indebtedness income, or both.
Cancellation of debt (COD) income. You have COD income if you were personally liable on the mortgage debt, you were discharged of the debt (and therefore are no longer responsible for paying the unpaid portion of the debt after the foreclosure), and the amount of the debt prior to foreclosure exceeded the amount of the debt satisfied through the transfer of the property to the lender or a third party purchaser.
If the entire fair market value [FMV] of the property foreclosed upon is applied in satisfaction of the debt, the amount of COD income generally equals the excess of the debt prior to foreclosure over the FMV of the property. For example, if your debt prior to foreclosure was $200,000 and the FMV of the property was $170,000, you would have $30,000 of COD income. COD income is ordinary income and is reported on line 21 of your return.
Effect of other liabilities on FMV. The existence of other liabilities, such as property taxes, can either increase or reduce the amount of your COD income. For example, there may be unpaid property taxes that are treated as imposed on you for federal tax purposes. If you have not provided funds to pay the property taxes, the taxes generally either remain as unpaid charges against the property after foreclosure or must be satisfied from the sale proceeds from the foreclosed property prior to any application of such proceeds to satisfaction of the debt. The unpaid liabilities reduce the amount of the FMV of the property that is available for satisfaction of the debt and must be taken into account in computing the amount of COD income. Thus, if in the example above you had $10,000 of unpaid property taxes, the FMV of the property available to satisfy the debt would be only $160,000 ($170,000 FMV less $10,000 unpaid taxes). Therefore, your COD income would be $40,000 ($200,000 debt less $160,000 FMV).
On the other hand, if you pay property taxes that for federal income purposes are treated as imposed on the owner of the property, this may reduce the amount of your cancelled debt income. Thus, if you paid $10,000 of property taxes that for federal income tax purposes are imposed on the owner of the property after the foreclosure, your FMV would be $180,000 ($170,000 plus $10,000) and your COD income would be $20,000 ($200,000 debt less $180,000 FMV).
Exclusion of COD income. You may be able to exclude all or part of the cancelled debt income if all or part of the debt was discharged in bankruptcy, if you were insolvent immediately before the transfer, or if the debt is a qualified farm debt or qualified real property indebtedness.
Gain (or loss) on disposition of your house by foreclosure. You may be required to compute gain on the disposition of the property and, under certain limited circumstances, may be eligible to claim a loss as well. [Please Note: A sentence appearing here in the original version has been moved to the end of the next paragraph.] If the house is your principle residence, you may be able to exclude part of all of the gain and deductible losses on the sale of your home.
Computation of gain or loss in general. Gain or loss is the difference between your amount realized and your adjusted basis in the property . In general an amount realized by transferor on a foreclosure or other transfer of property is the sum of : (1) the amount of the money received; (2) the FMV of any other property received; and (3) the amount of any other liabilities that the transferee (the person acquiring the property) either assumes or takes the property subject to. However, the tax treatment of a disposition may be affected by whether the debt was recourse or nonrecourse.
Recourse versus nonrecourse debt. If the mortgage debt is recourse, you can be held personally liable for its payment. If the debt is nonrecourse, the lender can look only to the property, not to you, for repayment.
Nonrecourse debt: face amount of the debt and no COD income. If your mortgage debt is nonrecourse and your house is foreclosed upon, your amount realized must include the face amount of the unpaid mortgage debt. Thus, if the amount of the nonrecourse debt is $200,000, the FMV of the property is $170,000 and the adjusted basis of the property is $120,000, your gain on foreclosure is $80,000 ($200,000 amount realized less $120,000 adjusted basis). No portion of the gain on the property subject only to nonrecourse debt is income discharge of indebtedness.
Recourse debt - in general. If the debt was recourse, the proper treatment depends on the amount of the debt, the FMV of the property, and whether you fully satisfied the debt by payment or instead were discharged of all or part of the debt as a result of the transaction.
Recourse debt: FMV of property greater than or equal to the amount of debt. If the FMV of the property foreclosed upon is greater than or equal to the mortgage debt and the debt is recourse, the foreclosure is treated entirely as a sale or exchange, with the gain (or loss) being the difference between the amount realized and the adjusted basis of the house. For example, if the FMV of the property is $200,000, the amount of recourse debt is $170,000 and the adjusted basis is $120,000, the transferor's gain on the foreclosure is $80,000 ($200,000 amount realized less $120,000 adjusted basis). There is no COD income in this situation because the FMV of the property is sufficient to satisfy the debt in full.
Recourse debt: FMV of property less than amount of debt. If the FMV of the property is less than the amount of the mortgage debt the debt is recourse, and the debt is discharged, the disposition by foreclosure (or by a deed in lieu of foreclosure) has two components. First, the difference between the amount of the debt and the FMV of the property is COD income. Second, the difference between the FMV of the property and the property's adjusted basis is treated as gain (or loss) on sale. For example, if the debt is $200,000, the FMV of the is $170,000, and the adjusted basis is $120,000, you have $30,000 COD income ($200,000 debt less $170,000 FMV) and $50,000 of gain ($170,000 FMV less $120,000 adjusted basis).
Sometimes a recourse debt is not discharged by foreclosure because the creditor can still collect the balance of the debt from you. In that circumstance, you would not have COD income until the debt was actually discharged or the statute of limitations on collection of the debt expired. If the debt is not discharged at the time of foreclosure, the gain or loss at that time is still the difference between the FMV of the property and its adjusted basis. Thus in the example immediately above you would have $50,000 of gain (which might be excludible under I.R.C. 121) at the time of foreclosure, with the COD income coming at a later time.
This Information has been Provided by a CPA Mom. This information is for general information only.
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