Forced home sale can result in income to the borrower.When the real estate market was booming, many homeowners either borrowed heavily to buy in at the top or took out home-equity loans Home-Equity Loan A consumer loan secured by a second mortgage, allowing home owners to borrow against their equity in the home. The loan is based on the difference between the homeowner's equity and the home's current market value. , which added to their debt. Now that the real estate market has cooled, some homeowners are waking up to an unpleasant reality: They can't make their mortgage payments, and their debt exceeds the property's fair market value. Often a foreclosure foreclosure Legal proceeding by which a borrower's rights to a mortgaged property may be extinguished if the borrower fails to live up to the obligations agreed to in the loan contract. , which may be only a missed mortgage payment or two away, is the inevitable conclusion to an otherwise uncertain situation. But the homeowners not only owe money to the bank, they can also face some unexpected income tax consequences if the unpaid amount of the loan is forgiven by the lender. Typically, lenders do not want to own real estate. They will go to great lengths not to foreclose fore·close v. fore·closed, fore·clos·ing, fore·clos·es v.tr. 1. a. To deprive (a mortgagor) of the right to redeem mortgaged property, as when payments have not been made. b. . It is a lengthy and costly process. They are in the business of lending money, not owning real estate. A foreclosure puts a nonperforming asset Nonperforming asset An asset that is not effectively producing income, such as an overdue loan. nonperforming asset An asset that produces no income. on the lenders' books. DEBT DISCHARGE INCOME A foreclosure (or deed in lieu of foreclosure A Deed in lieu of foreclosure is a deed instrument in which a mortgagor (i.e., the borrower) conveys all interest in a real property to the mortgagee (i.e., the lender) to satisfy a loan that is in default and avoid foreclosure proceedings. ) can result in income to the borrower if the lender forgives some or all of the unpaid debt. In general, cancellation or forgiveness of a debt results in gross income--debt discharge income--for the borrower, unless an exception applies because the taxpayer declared bankruptcy or was insolvent INSOLVENT. This word has several meanings. It signifies a person whose estate is not sufficient to pay his debts. Civ. Code of Louisiana, art. 1980.. A person is also said to be insolvent, who is under a present inability to answer, in the ordinary course of business, the responsibility at the time of discharge. Borrowers must report this income on their tax returns (on the "Other Income" line of Form 1040 or on Schedule C), and certain lenders (for example, banks and other financial institutions) must issue a Form 1099-A, Acquisition or Abandonment of Secured Property, to the borrower, reporting the balance of the loan and the fair market value of the property. FORECLOSURE BY LENDER When a property is foreclosed on, the taking of the property by the lender in satisfaction of the recourse debt is treated as a deemed sale, with proceeds equal to the lesser of the property's fair market value at the time of foreclosure or the amount of secured debt. If the amount of debt exceeds the property's fair market value, the difference is treated as debt discharge income if it is forgiven. The bid price in a foreclosure sale foreclosure sale n. the actual forced sale of real property at a public auction (often on the court house steps following public notice posted at the court house and published in a local newspaper) after foreclosure on that property as security under a mortgage or is presumed to be the property's fair market value, unless there is clear and convincing proof A standard applied by a jury or by a judge in a nonjury trial to measure the probability of the truthfulness of particular facts alleged during a civil lawsuit. Clear and convincing proof means that the evidence presented by a party during the trial is more highly probable to the contrary. Debt discharge income occurs in a foreclosure transaction only if the lender discharges part or all of the debt upon taking the property securing it. If the lender fails to pursue the debtor or to discharge the balance, debt discharge income results when the status (under state law) for enforcing the debt expires. For a detailed discussion of the issues in this area, see Tax Clinic, "Short Sale or Foreclosure of a Principal Residence," by Steve R. Picha, CPA (Computer Press Association, Landing, NJ) An earlier membership organization founded in 1983 that promoted excellence in computer journalism. Its annual awards honored outstanding examples in print, broadcast and electronic media. The CPA disbanded in 2000. , and Yadira E. Hiraldo, CPA, in the September 2007 issue of The Tax Adviser. --Alistair M. Nevius, editor-in-chief The Tax Adviser |
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