THE DECEMBER, 2013, EXPIRATION OF TAX ON DEBT-FORGIVENESS UNDER THE AMERICAN TAX RELIEF ACT
Post Date: 11/4/2013
THE DECEMBER, 2013, EXPIRATION OF TAX
ON DEBT-FORGIVENESS UNDER
THE AMERICAN TAX RELIEF ACT
Do Modifications, Short Sales, Foreclosures, Deeds-in-Lieu
and Other Write-Downs Now Become Taxable?
By: J. ROBERT ECKLEY
Real Estate, Tax and Agency Attorney
October 1, 2013
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QUICK NOW! True or False? “After December 31, 2013, losses on mortgage debt reductions from workouts, modifications, short sales, foreclosures and deeds-in-lieu on residential property will be taxable again because the American Taxpayer Debt Relief Act which protected these debt reductions and write-offs from taxation expires then.”
ANSWER: In many jurisdictions: “False.”
Why? Because that is not how the taxation of debt relief works. One size does not fit all. In some states like Arizona, it hardly fits any; in others like California, it fits only a few and in others still like Oregon or Florida and others it “might” apply. So if you are telling all of your clients they need to hustle to get their short sales or other debt write-down deals done before the end of this 2013 using the simple statement quoted above as “the law”, the only “hustle” being given is the one you are giving to your clients to get them to close, as the taxability of debt relief just isn’t that simple.
GOING BY THE NUMBERS:
Let’s follow the tax trail here. Go back to 2007. The U.S. was awash with defaulted residential loans and people were rediscovering that for years previous and to that date, IRS had rules that could make some or all of that debt write- off taxable. That’s right. In SOME circumstances, a debt forgiven—a true loss to the debtor—could and still can be a taxable event. The first “balancing point” that could make a write-down or write-off taxable was and is whether or not the state in which the mortgage was issued allows mortgage deficiencies after a foreclosure. A “deficiency” state means one in which the creditor is allowed by law to pursue the debtor personally on any of the debt remaining unpaid even after a foreclosure or short sale of the property. A “non-deficiency or limited deficiency” state is one which will not allow the creditor to pursue the debtor for any post-short sale or post-foreclosure shortfall in paying off the debt or which will only allows it in limited amount or limited types of loans. Colorado is an example of a deficiency state. Arizona and California are examples of a non-deficiency and a limited-deficiency state, respectively.
To equal out the disparate treatments between states and give a break to taxpayers already hit with the Recession, itself, the national 2007 Mortgage Debt Forgiveness Tax Relief Act was quickly passed to provide both tax relief generally and tax relief parity for losses to debtors who were in states that were deficiency states in whole or part with those who were in states where deficiencies were generally barred.
The 2007 Act expired December 31, 2012, but was extended by Congress at the last minute in late 2012 to December 31, 2013 by the American Taxpayers Debt Relief Act of 2012 (commonly mis-cited as the American Taxpayers Debt Relief Act of 2013—they are the same).
The discharge in whole or part of deficiency or “recourse” debts has been a “potentially taxable event” under Internal Revenue Code (“IRC”) Section 108 for decades. It is not new. In 2007 the federalMortgage Debt Forgiveness Tax Relief Actwas just temporarily tacked to IRC 108 to cope with the housing collapse and add the interstate parities noted, above. It was aimed at adding more IRC 108-type exclusions to relieve taxes for those debtors who fit none of the three below pre-existing and long-standing IRC 108 exceptions and, as was said, to equalize the tax treatment of debt relief between those states where mortgage debt was non-deficient with those where it was deficient (39 states have some form of more extended residential debt deficiency in whole or part). The 2007 Act simply added additional temporary exclusions into IRC 108 as follows: (1) it made whether the loan balance excused was recourse or non-recourse irrelevant to calculation of both income and capital gain, as long as the loan was all used to purchase or refinance the property or fix it up, (2) it allowed the new exclusion to residential debt forgiven only up to $2 million, and (3) it applied these extra exclusions only to single family dwellings, and (4) it expired on December 31, 2012 and was then extended by the American Taxpayers Debt Relief Act as noted to December 31, 2013. But the expiration does nothing to the exclusions from tax that were already in IRC 108 and they remain now and after December 31, 2013.
THE EXPIRATION OF THE ACT IS MORE MOLEHILL THAN MOUNTAIN
For those taxpayers in states where mortgage deficiencies are generally the law, the expiration of the American Taxpayers Debt Relief Act on December 31, 2013 (assuming it is not extended once again by Congress) “might” be bad for them, but then only if, going back to IRC 108 before the amendments were tacked on, they are not eligible under the other shields from being taxed, (discussed below). For those in states where there are no or highly limited deficiencies, the Debt Relief Act amendments never did much for them, as they were already protected under the original IRC 108 rules (discussed below). So even with the expiration of these amendments, if one still passes muster under the OLD exceptions under IRC 108, one is still out of the tax woods.
FOCUSING ON THE IRC 108 EXCLUSIONS THAT STILL PROTECT AND DO NOT GO AWAY IN DECEMBER, 2013
To understand why the industry, as a technical issue, may be making a mountain of a molehill, it is necessary first to understand how the “tax on debt forgiveness” works.
THE “PHANTOM GAIN” RULE: As backwards as it sounds, IRS and local Revenue Services can tax certain actual losses as implied gains and that includes actual losses on one’s real estate and other debts and investments. For many years IRC Sections 61 and 108 of the Internal Revenue Code have taxed the debtor upon real estate debt that a creditor has forgiven (such as by a short-sale, foreclosure, a deed-in-lieu or a write-down) on the debtor’s real estate trust deed or mortgage debt. The rule applies to other debts, as well, but real estate debt is the focus here. The economic reasoning behind this is the concept that being relieved from a lawful debt is the same as the taxpayer receiving beneficial gain equal to the amount that is being relieved. IRS runs three tests of the transaction to determine, first, if there is “phantom income” in the debt write-down or write-off and then, second, whether there are “phantom capital gains” on it. Then, finally, and regardless of the result of the foregoing the third test is whether the debtor is insolvent or in bankruptcy and protected regardless of the first two tests. In sum, there are some huge exceptions that tend to swallow the “tax-the-loss” rule and still shield the taxpayer.
Exceptions to debt forgiveness taxability
THE EXCEPTIONS TO THE “PHANTOM INCOME” RULE: IRC Sections 61 and 108 has always had three main exceptions to the application of the “phantom income” taxation rule, above, and these applied in the past and they apply now and they will apply after December 31, 2013, no matter what happens to the old amendments. As stated, above, there are three legs or tests of the tax analysis to determine if the debtor lands on his feet with little or no tax.
First, the federal revenue rule does not apply if the loan being forgiven has no personal recourse (is a non-deficiency loan as discussed above) as a matter of state law governing the loan. See section 61(a)(12), IRC 7701(g), Treas. Reg. 1.1001-2(b) and (c), Example 7, and Commissioner v. Tufts, 461 U.S. 300 (1983) and Estate of Jerrold Delman, 73 TC 15 (1979). Second, the rule does not generally apply if the taxpayer is insolvent at the time it is forgiven. Third, if the taxpayer is in bankruptcy at the time of the debt relief, the “gain” rule also does not generally apply.
EXAMPLE: In Arizona, a loan secured by and used to purchase a property of 2.5 acres or less on which there is at least one and not more than two dwelling units capable of residential occupancy or in which there is evidence that residential occupancy of such units is intended (such as new construction of a home or a duplex that is not yet completed) are treated as NON-DEFICIENCY LOANS. Even a refinance of such loans in which no new money is taken out is on breach NON-DEFICIENCT as to the borrower. Even if the loan was divided into a first and second lien against the property, as long as both were used to buy the property, it is still non-deficient. Accordingly, in most cases (see formulas below), no tax See “FAQs” at www.eckleylaw.com.
EXAMPLE: In California purchase money loans for a single family residence in which the borrower resides or a four-plex in which the debtor resides in one unit generally have no deficiency and, for refinanced purchase money loans generated after January, those, too, are no more deficient than the loans they refinanced. There is a good argument that second trust deeds and mortgages used to actually purchase the home are non-deficient. All seller-carries on the same type of residential property have no deficiency. In some cases, the method of foreclosure will not permit a post-foreclosure deficiency action. Note: This is not available in California if the borrower’s title is held as an LLC or other artificial entity. Assure that the title is in the name of a natural person before the loss! There is, however, law in California that suggests the short-saling of an otherwise non-deficient loan originated before January may still produce a deficiency to the extent it does not satisfy the loan balance, but the lender is required to clearly note that to the borrower in the short-sale paperwork or else the potential deficiency eligible for a collection action is waived. See “FAQs” at www.eckleylaw.com and for the deficiency rules in selected other states.
What the above discussion means is that in the Arizona example and to the extent noted in California example (and some other states but sticking with these examples here for simplicity in this discussion), the debt reduction, forgiveness, short sale, foreclosure, deed-in-lieu or write-off on most all home loans has NEVER been a taxable event under IRC 108 for the last number of decades. The 2007 Act did not change that and neither did the 2012 Act and even without those Acts these loan write-downs and write-offs were not taxable because in Arizona and to a large extent in California they were and are non-deficient by law. THAT LAW WILL NOT CHANGE ON DECEMBER 31, 2013, EVEN IF THE 2012 ACT IS NOT EXTENDED.
The “Second Leg” of the IRC 108 Analyses
“PHANTOM CAPITAL GAIN” (OR LOSS): Before one jumps for joy under the above first test, there is still one more IRC test, but it is noted that almost everyone excluded in the first test, above, is also excluded in the second one.
In addition to the above first test to determine if “phantom income” is to be recognized, IRS then applies the capital gain/loss rules tests to determine if any “phantom capital gain” is to be recognized. See, id., again, the above legal citations. It is a long statutory ride to work through the formula which only CPAs and lawyers and people who study insects could love, but in a nutshell it is essentially this: IRS rules assume in a short sale or foreclosure or deed-in-lieu (where no other action for the debt was undertaken by the creditor) a fiction that the property was substantively “sold” and then, accordingly, applies the rules (with one variation) for calculating capital gains or losses recognized on regular sales of real property. Those run as follows: IRS assumes the “price” at which the property was “sold” was the higher of either the debt relieved or the fair market value (“FMV”) at the time of the debt was forgiven. That amount is then subtracted from the adjusted gross basis of the property (original purchase price plus additions), which, in most cases, usually ends up with a “loss” (after all, if there was no loss and the property could show a profit in a conventional sale, why on earth are we giving it back, right?).
This “fictional sale price” formula can conceivably show a “fictional capital gain” (it never does in 99% of the debt settlement cases out there in non-deficiency states and even less in deficiency states where market valuations are more suppressed) but in most all cases where the property is a principal family residence the generous gain disregard allowed by IRS on the sale ($250,000 gain disregarded for a single taxpayer of married filing separately, $500,000 gain disregarded for a married couple filing jointly) offsets any potential liability, even in those 1% of the cases where there is one. See IRC 121. Unfortunately, losses on the principal family residence are not deductible, but in this usual analysis and in the usual case, at least they are not taxable, either. Reg.1.165. But a loss on it if it was a business asset (used for rental or investment) is deductible and so in those cases, not only will there be no tax, there will likely be a tax deduction for the borrower. Reg. 1.165-9. Very few fictional capital calculations in the Arizona or California examples noted are gains and even where they are most are exceeded by the disregarded gain amounts under IRC 121. Even in those states where the creditor can pursue a debtor for any short fall, in most cases, the failed property is still usually worth less than the debt against it and the FMV is almost always below the taxpayer’s basis, so there are little or no capital gains taxes before IRC 121 disregard, let alone after it, anyway.
The Third Leg of the Test:
THE TRUMP CARD: THE DEBTOR IS ACTUALLY BROKE: If the debtor is insolvent or bankrupt at the time of the debt relief, this is a trump card making all of the foregoing testing an unnecessary exercise as the debtor is in that case excluded entirely from this tax historically, now and in the future, regardless of the expiration of the tax relief acts. This “genuinely broke borrower” test applies to most losses, not just mortgage losses and applies even to commercial losses and also applies to those in any state, whether or not the state recognizes deficiencies on mortgage short-falls. In those cases where debtors are actually, genuinely broke or losing everything or in a bankruptcy, neither the state nor IRS is going to tax them for the debt relief under IRC 108.
To be noted in both the Arizona and California examples, what is not federally taxable under IRC 108 is also observed by these states and most (not all) states and so it is also not taxed or rarely so at the state revenue department level.
SUMMARY TO THIS POINT:
With tax law now explained, it can be seen that almost all of the consumer residential debt out there will not be affected very much by the expiration of the American Taxpayer Debt Relief Act of 2012. For those debtors on hard times not protected by the “non-deficiency” exclusion, most are usually insolvent, anyway (otherwise, why are they here?), and that is the Grand and Final Tax Trumps under IRS 108.
OTHER DEBTS AND OTHER DEBT RECOURSE RULES:
Are there debts that still escape these analyses? Yes, some. And not being taxable on the loss isn't the same thing as being immune from the creditor suing the borrower on the loss in a recourse action. In deficiency states or on loans or loan shortfalls in which recourse is allowed by state law, the creditor could still elect to try to collect the debt by suit or other actions. It's just that in most cases the Taxman is not going to add insult to injury by taxing it!
THERE ARE OTHER DEBT-FORGIVENESS CAVEATS:
The advice to “short sale quickly before the end of December, 2013” might be effective for someone very solvent in a deficiency state or someone very solvent with something like a large home improvement loan secured by their home in a state where the improvement loan creditor has full recourse against the borrower (as is the case in of the Arizona and California and most other states). In that case, the discharge would run a high likelihood of being taxable if done after December 2013 (assuming the Relief Act is not extended). Do remember that VA loans have a form of recourse back to the qualifying Vet in that VA, after making good to the lender on a defaulted debt which VA guaranteed, can pursue the Vet for repayment on the Vet’s VA program as a direct personal obligation to VA.
There are also other tax ramifications of debt and property adjustments, some even “positive”, that neither IRC 108 nor the Relief Act of 2012 cover and are set forth elsewhere in the tax Code. For example, any taxable gains that may result from the debt-forgiveness rules for a given taxpayer may still be offset by other losses of the taxpayer. The gain is only a line item in the taxpayer’s return and is still netted with applicable gross deductions, credits, carryovers, carrybacks and other offsets elsewhere on the return. Accordingly, the net tax, even if the above formula recognized some gain might still be buried in other overall losses so that the net tax is still “zero.” Equally, but also sadly for some debtors, some short-sales or debt-reduction modifications can generate gains from OTHER SECTIONS of the Code such that as those recognized under the “mortgage-over-basis” or the depreciation recapture rules for business or investment use. These could be big, especially for the loss of a property that had its gains rolled into successive IRS 1031 exchanges, for example. Real property “dealers” often do not get similarly favorable treatments as, to them, the property is inventory. But these “side issues” have more to do with taxes generally, and the financial structure of the taxpayer specifically and neither IRC 61, 108 nor the 2013 Act changed any of that.
RESIDENCY: Some state or local revenue departments do not follow the Federal IRC 108 rules and the application of the rules at the local tax level may vary by the non-U.S. or tax residency of the taxpayer. Some jurisdictions do not base their tax rules upon the jurisdiction where the property is located, but rather upon the rules of the jurisdiction where the taxpayer resides or pays taxes. The taxpayer should check with the Revenue Departments for the state, county and city (and country) of tax-residency for the rules there.
HOW REPORTED TO REVENUE SERVICES: IRC Sections 61 and 108 "phantom gains" will be reported to IRS and other revenue authorities by the lender automatically through a 1099-A or 1099-C (though the taxpayer is also responsible to include it in his returns whether or not reported). However the creditor couches it in the 1099 can, if wrong, be contested on the debtor’s final returns as being” mis-cast.” See specifically in the newest Form 1099s a specific box (usually marked “Box 5”) in which the creditor can check off whether the loan was a “personal obligation” (non-deficiency) or not. Often the creditor (whether by mistake or sheer nastiness) gets it wrong and checks off the most onerous, most taxable classification of the debt. The taxpayer can challenge that classification in his or her returns for that tax year. IRS Form 982 may be filed to claim any relief from phantom income for which the taxpayer might be alleged to be eligible, in addition to other normal tax offsets where that relief is not available. These rules, form numbers and other applications are subject to change.
PRACTICAL FACTS: SOME “INTEGRITY” MUST COME INTO THE GAME
Query: In a non-deficiency mortgage state where the consumer is not going to be taxed on any losses anyway under the rules and where the consumer cannot be sued for a shortfall in a foreclosure or deed-back and when the consumer has no money to even rent another place to stay, wouldn’t the best consumer advice be to forget modifications and short sales and instead advise the consumer to stay right where he is --with at least a “free” roof over his head—and to just save up whatever money he can and ride the foreclosure process out to the end? When there is no worse jeopardy to the consumer in doing so, why would anyone think the best advice is to rush the consumer and his family out of the only safe and free shelter they are likely to have so that they can then pitch a tent in the park? Urging the consumer to short-sale himself right out of the only shelter he or she and his family are likely to have for a long time after they leave makes it abundantly clear that to this real estate agent it is “all about the commission and screw the consumer.” Any agent doing that when he or she knows better is likely defrauding the consumer. And if the agent does not know better, he or she is at least negligently disserving the client. Either way, the agent still becomes eligible for lawsuits and licensure complaints when the consumer later finds out (about tax time) that he was bamboozled and could have waited out a foreclosure that would have taken months or even a year or more and saved up his money without any more legal or tax jeopardy than the short sale and that the short sale bought him nothing extra but a sooner flop in the park without any chance at all to save up some money for the final exit. Some would call this kind of loss of a potential commission when the debtor is properly advised and elects to stay in his home and save his money as long as he can “a crying shame.” The more enlightened would call it “integrity.”
ILL-MOTIVATED TAX DISINFORMATION
The above points are extremely important because many lying lenders, ill-motivated short-sale brokers and very ignorant real estate educators and journalists out there are spewing the disinformation (and in some cases the flat lie) that all of this tax avoidance ends in 2013 and after that all debt forgiveness is taxable thereafter and so borrowers need to “engage a broker and short sale immediately” (or do something else profitable to those giving the disinformation) to “beat the tax by the end of 2013.” There are even reports of some “guru” out there saying that after December 31, 2013, under the 2012 Act, all loans somehow magically become deficiency loans! Huh? While smoking what? These words from these mouths should be received with the same effect as would be winds from a cesspool. These “experts” would profit from a short course in how IRC 108 and the capital gains rules actually work….and probably also from a long, long course in integrity, as they are categorically and unequivocally dead wrong and many of them know it but are using this “advice” to consumers for no more noble of reason than to give the consumer a “bum’s rush” to a commission-producing short sale that may not be in the consumers best financial, tax, legal interest, at all.
CONCLUSION: “BE THE SOURCE OF THE SOUCE AND NOT THE SOURCE”
Getting the customer or client to someone for a professional opinion on the legal and tax status of a deal before it goes hard is mandated not only under malpractice law, but also under licensure law. In all jurisdictions the legal and tax ramifications (at least the adverse ones) of an act are a “material matter” needing disclosure in writing to the client or customer by real estate licensees associated with the deal. The licensees can assure that disclosure by assuring that a lawyer and a CPA or a lawyer familiar with the tax laws is consulted by the consumer. The proper disclosure level for the real estate broker is to advise them that there are legal and tax ramifications to their deal (many specific to them and having to do with their COMPLETE financial status, not just that single debt) and send them to the CPA or lawyer, but the broker must avoid giving that actual legal or tax advice or opinion, themselves, as that’s the second place where lawsuits and licensure revocations lurk. And most licensees are NOT INSURED for it as giving unlicensed and incorrect tax and legal advice is considered by insurers to be outside the scope of legitimate licensed real estate activity.
There is an old and very valuable mantra in skilled real estate agency work. It’s been around for a couple of decades, now. It goes like this: “As to matters outside of one’s skills, knowledge and especially one’s licensure, be the source of the source, but never the source”. One should refrain from the urge to give or purport to give information that is beyond one’s licensure or skill-set—get the consumer to someone who has all of the right credentials to give it to them. Accordingly in the present context, there is only one sin greater than trying to be the client’s unlicensed CPA and unlicensed lawyer by giving them tax and legal advice and that is to give them BAD unlicensed tax and legal advice!!
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