Q: I understand that the number of foreclosures has increased in recent years. I fear that my daughter and her husband may be next. Someone told me that if her debt is cancelled, she will have to treat the amount forgiven as income, even if she doesn't get any money from the sale. Someone else said she would be taxed on what she actually made like a regular sales transaction. What should she know?
A: The first thing she should know is that she needs professional advice. This is the kind of question that has so many "what ifs" that a comprehensive answer would read like a legal opinion. Generally speaking, there are two different taxes that may be assessed against your daughter: ordinary income and capital gains tax.
First, she should know that the deficiency is not always forgiven in the sale of property that does not return enough funds to fully satisfy the debt. Your daughter could remain owing the amount still owed and the lender would presumably continue to try to collect it. If she hasn't made money during the foreclosure no taxes would be due.
If the debt is actually forgiven, Section 61 (a) of the Tax Code may apply. It states that "gross income means all income from whatever source derived, including income from discharge of indebtedness ..." Your daughter may be unaware that this provision may apply to her situation.
On the other hand, if she has other debts at the time of the foreclosure (credit cards or car loans) which exceed her assets, she could be considered "insolvent" and will not have to pay any tax. According to the IRS, she should determine her liabilities and the fair market value of her assets immediately before the cancellation of the debt to determine whether or not she is insolvent and the amount by which she is insolvent. (IRS Publication 908, Bankruptcy Tax Guide).
Typically, cancellation of debt does not apply on the foreclosure of a home and the amount of unpaid debt is not treated as straight income. A foreclosure is treated the same as the sale of a home. Her cost-basis of the house will stay the same as if she sold the house. The amount of debt forgiven is treated as her sales price resulting in a capital gain or loss.
If she ends up showing a capital gain, she may still use the home exclusion rules to exclude up to $250,000 of that capital gain ($500,000 for married filing joint). There are also rules that apply to claiming this. For example, she must have lived in the home for two of the last five years.
There is usually a significant amount of money in jeopardy in a foreclosure transaction. This is definitely time to seek the advice of a legal professional.
Attorney Sylvia Heldreth is a Certified Specialist in Real Estate Law. Her office is located at 1215 Miramar St. in Cape Coral.
This article is not intended as specific legal advice to anyone and is based upon facts that change from time to time. Individuals should seek legal counsel before acting upon any matter involving the law.