Forclosure Tax Effect: Imputed Income From Debt Forgiveness May Be Offset By Investment Losses

Many people facing foreclosure are concerned about income tax liability from the lender’s forgiveness of mortgage debt. If the mortgage lender does not pursue a deficiency judgment and writes-off the loan after foreclosure the lender could send the owner a IRS Form 1099 for imputed income for the amount of debt forgiven. In the case of a first mortgage, the debt forgiveness would be the difference between property value and mortgage loan balance; a second mortgage write-off creates an imputed income issue for the entire amount of the loan. There is no imputed income from debt forgiveness on your primary residence. Most imputed income issues are related to foreclosure or short-sales of investment property or second homes.
In response to a question from a Miami attorney I spoke with a local CPA concerning income tax treatment of debt forgiveness of investment real estate. The CPA is Lonnie Young. (usataxhelp.com) Mr. Young explained that imputed income after foreclosure and debt forgiveness often is offset by tax losses on the real estate investment.

Consider the example of a person who buys a house for $200,000 with a $180,000 mortgage. The house is lost to foreclosure when the value is $100,000. The lender sends the owner a 1099 for imputed income of $80,000 (mortgage balance less fair value). The foreclosure is a completed after which the owner has realized a tax loss of $100,000 ($200,000 purchase price less $100,000 value at foreclosure sale). The loss offsets imputed income so the taxpayer pays no additional tax.
The ultimate tax effect of imputed income depends on the owner’s use and tax treatment of the subject real estate. The CPA said that in the case of investment property, including vacant land or houses, the loss is a capital loss which is limited to $3,000 per year . If the house qualifies as Section 1231 business property (including rental property) the tax loss is characterized as a business operating loss which the taxpayer can write off fully in the year of sale. Based on what Mr. Young said, if your home facing foreclosure is rented for income then your tax loss would offset any imputed income from debt forgiveness. People facing foreclosure or short-sale of houses other than their primary residence may benefit if they have rented the home a current market rent even if the rent does not cover the mortgage payment.
The IRS may challenge the characterization of a 1231 business property where the property has been rented for less than 1 year prior to the foreclosure sale. Mr. Young said the IRS almost never challenges the one year write off where the home has been rented for more than two years.
You must discuss your individual situation with your own CPA or tax attorney. My discussion of this topic is based on a non-written opinion of one accountant. I am not a tax attorney and have not independently researched this important tax issue.

Last updated on May 22, 2020

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