When it comes to cancelled debt on real estate it generally comes from either a foreclosure or from a short sale. A foreclosure is when the lender repossesses a property from the borrower due to the loan being in default for an extended period of time. A short sale is when you sell real estate but the loan balance exceeds the sale price of the property. Let’s take a closer look.
Foreclosures
In the event of a foreclosure you will generally receive a 1099-A. Form 1099-A offers a few key pieces of information:
- The date of lender’s acquisition
- The outstanding balance of the mortgage
- The fair market value of the property
The difference between the outstanding balance of the loan and the fair market value is generally considered the amount of cancelled debt.
Occasionally a lender will provide you with a 1099-C instead of a 1099-A. 1099-C works a little differently. 1099-C includes:
- The date the debt was discharged
- The amount discharged
- The fair market value of the property
- A check box which designates if the debtor was personally liable for the debt
That check box lets us know if it was recourse or non-recourse debt. In some states, including Oregon and California, there are laws that dictate if lenders can take recourse against borrowers for certain types of debt. In these states debt that is secured by real estate is considered non-recourse debt and if the lender acquires the property they are barred from any further action to collect the debt from the borrower.
If your mortgage is a non-recourse loan the foreclosure is treated like a sale. The “gain” is figured by finding your adjusted basis in the property, which includes any improvements you made to the property that would adjust your basis and then subtracting the total from the balance of the mortgage when the property was foreclosed. Both the fair market value and the mortgage balance should be included on the 1099-A you receive from the mortgage company.
After the Mortgage Relief Act of 2007, there has been a provision to exclude the gain from a foreclosure of your main home, which is the home you live in most of the time. The exclusion was limited to $1 Million ($2 Million if married filing jointly). This exclusion is only available on acquisition indebtedness, money that was borrowed to purchase, build, or improve your primary residence. As of this writing the exclusion was only approved through the 2014 tax year and it is uncertain if this provision will be extended for the 2015 tax year or beyond.
Short Sales
A short sale is when you sell real estate for less that the total debt owed on the mortgage. There is generally a negotiation process with one or more of the lien holders on the property to accept an amount less than the amount that is owed. Short sales are similar to foreclosures since you will be taxed on the “gain” after the sale of the property, but instead of fair market value you will used the sales price, plus any adjustments to the basis to figure out the “gain” on the property.
If the property was your main home the gain on a short sale could also be excluded from income via the Mortgage Relief Act of 2007 as well, but it is unknown if this act will be extended to future years.