Tax Implications of Loan Modification, Short Sale and Foreclosure of Principal Residence

By Frank Minuti, CPA

A taxpayer asked "which is better, a short sale or foreclosure where the outstanding debt on their personal residence exceeds the current market value?".

My first suggestion is that the homeowner should discuss a loan modification with the lender. A loan modification is a permanent change to the loan agreement that modifies any or all of terms including principal balance, interest rate and term of the loan. The goal of the loan modification is to make the loan affordable to the debtor.

If a loan modification is not attainable then the short sale could be considered. A short sale is where the homeowner works out an agreement to allow the owner to sell the property for less than the debt on it. The lender may accept less than full payment on the sale or the lender may require the homeowner to pay the full amount or somewhere in between the sales price and the total debt owed. Generally the lender will not allow a short sale if the debtor is current on payments. The lender will also want to see the debtor’s total financial position (both income and assets) to substantiate that the debtor cannot afford to keep making the mortgage payments or to pay off the remaining balance.

Foreclosure is the legal process that allows the creditor to repossess the property when the debtor is in default on the loan obligation. The lender than sells the property and applies the net sales proceeds against the debt owed.

Loan modifications, short sales and foreclosures can all result in cancellation of debt income (COD). The COD income is the amount of any principal reduction resulting from a loan modification or the amount of dollars the lender agrees to reduce the debt by on either a short sale or the foreclosure and subsequent sale by the lender. This COD income may or may not result in taxable income to the debtor.

Most equity loans and lines of credit as well as many mortgage loans that replaced the original acquisition loan are recourse loans. Lenders have the right to pursue debtors for any loss on the short sale or foreclosure if the debt is recourse. Many lenders are writing of the losses and not at this time going after debtors for losses on recourse loans. You should seek legal counsel to determine your potential liability if your debt is recourse.

A taxpayer generally does not incur taxable COD income when the debt is non-recourse or discharged through bankruptcy. If the debtor is insolvent some or all of the debt may not be taxable.

Taxable income can result when the lender cancels all or part of a recourse debt during a loan modification or short sale where the lender writes of a portion of the loan or the lender incurs a loss resulting from a foreclosure and subsequent sale.

Beginning January 1, 2007 through December 31, 2012, the federal government allows taxpayers to exclude from taxable income COD income of up to $2,000,000 ($1,000,000 if married filing separate) the discharge of qualified personal residence indebtedness. Qualified personal residence indebtedness is acquisition indebtedness as defined in Internal Revenue Code Section 163(h)(3))b) and is defined as debt incurred in acquiring, construction or substantially improving any qualified residence.

When acquisition indebtedness is refinanced the amount of the new loan that is equal to the payoff of the acquisition loan is treated as acquisition indebtedness but any dollars in excess of that do not qualify and are taxed as COD income if forgiven or cancelled by the lender. California partially conformed to the federal COD income provisions for transaction on or after January 1, 2009 but limited the qualified principal residence indebtedness to $800,000($400,000 for married filing separate) instead of the federal $2,000,000 ($1,000,000 if married filing separate). California further limited the COD income exclusion to a maximum of $500,000 ($250,000 if married filing separate).