How do I Report a Short Sale?
In prior issues of Tax News we have addressed several issues related to foreclosures. In our February 2010 issue, we addressed how the State of California civil procedures interact with the Internal Revenue Code 108.
Four questions repeatedly come up regarding the proper treatment of a foreclosure/short sale. These four questions are:
- How do I report a foreclosure on property located in another state?
- What do I do if the taxpayer moves into or out of California before or after a foreclosure?
- How do I report cancellation of debt (COD) income if the creditor has not issued or refuses to issue a 1099C?
- How do I report a short sale?
The answers depend on each individual’s facts, but first you must determine what type of a loan you are dealing with; that is, are the loan(s) at issue recourse or non-recourse. In some cases you may be dealing with a client that has both a recourse and a non-recourse loan.
Although California has rules/law governing what a creditor can do to recover “purchase money” loans, California’s rules are not binding in another state. The answer to the recourse or non-recourse question is based on the state’s laws in which the property is/was located. Like California, each state has its own set of rules concerning what a creditor/lender can do to collect a debt. If your client's property is located outside California and sold as a foreclosure, sale under the deed of trust or mortgage, or short sale,1 you will need to review the creditor laws in that state to determine the proper classification of the loan(s) at issue. If the lender is able to pursue the borrower for payment of the remaining balance of the debt after the property is sold, the loan is recourse. If the lender's only remedy is to repossess the property used as collateral, the loan is non-recourse.
The type of loan also dictates how you report the deemed sale of the property.
Forgiveness of a non-recourse loan resulting from either a foreclosure or a short sale will not generate cancellation of debt income (COD). However, you do still need to address the other tax consequences, like reporting the sale (deemed sale).
The Form 1099A is issued when a borrower abandons secured property, or when a lender acquires property in full or partial satisfaction of a debt and the property was used as security for the debt. This is when you are treated as having a deemed sale.
If the debt is nonrecourse and the debt is discharged in connection with the sale or other disposition of the property, the full amount of debt is treated as part of the amount realized and the transaction is treated as a capital gain or loss. See IRC 7701(g) and Reg. 1.1001-2.
IRC section 7701(g) states the deemed sales price (FMV) cannot be less than the amount of any nonrecourse indebtedness to which such property is subject. Meaning you must use the outstanding debt as your sales price for purposes of determining if you have a gain or a loss, even if the amount of the debt is more than the sales price (FMV) of the property (short sale).
The 1099C is issued once/if the creditor abandons their right to collect a balance due (the deficiency) from the debtor of $600 or more, and there is an identifiable event.
You do not have COD income until your debtor(s) cancels the debt (when the creditor(s) abandons their right to collect). IRC 61(a)(12) requires the inclusion of COD income; IRC regulation 1.61-12 states it is the discharge of indebtedness that results in the realization of income. Your creditors may not cancel the debt (this depends on what the state creditor laws allow) and may pursue collection of the full deficiency, in which case you would not have COD income to report.
For a recourse loan, you report the difference in the property’s FMV and the outstanding balance as COD income in the year in which the lender forgives the deficiency. Generally, a 1099C is issued. You need to determine if one of the provisions in IRC 108 applies, which allows the COD income to be excluded based on the laws in place in the year of the discharge.
You report the deemed sale using the FMV as your sales price and use your basis to determine if you have a gain or a loss.
When you are dealing with a client that has changed their state of residency, the issue involves the determination of when you have taxable COD income and the sourcing of such income. This may be a fact-intensive analysis, and the answer may change based on the specific set of facts.
A California resident is taxed on all income, regardless of it source. A part-year resident is taxed on all income for any part of the taxable year the taxpayer was a resident of this state, regardless of source, plus for any part of the taxable year the taxpayer was a nonresident, income derived from sources within this state. A nonresident is taxed if they have California sourced income. R&TC section 17951 regulations provide guidance on nonresidents' income from sources with this state. Regulation 17951-3 provides for the inclusion of gains realized from the sale or transfer of real or tangible property in this state.
So if the lender does not discharge the indebtedness until after the taxpayer has become a California resident, it would be taxable to California, regardless of where the property was located.
California law currently allows taxpayers who had all or part of the loan balance on their principal residence forgiven by their lender to exclude the forgiven debt from California gross income. California law conforms, with modifications, to federal mortgage forgiveness debt relief for discharges that occurred in tax years 2007 through December 31, 2012. The amount of qualifying indebtedness is less than the federal amount, and California imposes a state-only limitation on the total amount of relief excluded from gross income. For more information, go to our updated Mortgage Forgiveness Debt Relief webpage.
Additionally, the IRS has issued several informative articles and publications on foreclosures/short-sales available at irs.gov.