31.9 Foreclosures, Repossessions, Short Sales, and Voluntary Conveyances to Creditors

If you are unable to meet payments on a debt secured by property, the creditor may foreclose on the loan or repossess the property. A foreclosure sale or repossession, including a voluntary return by you of the property to the creditor, is treated as a sale of the property on which you must figure gain or loss. Similarly, if the lender agrees to a “short sale” for less than the outstanding mortgage balance in which it accepts the sales proceeds in satisfaction of the mortgage, you must figure gain or loss. A loss on a principal residence or other personal real estate is not deductible. If you were personally liable on the debt, then in addition to realizing gain or loss on the transfer, you also have debt forgiveness income from the cancellation of the debt to the extent the cancelled debt exceeds the value of the property, unless an exception (11.8) applies. For example, if you were insolvent at the time of the debt discharge, the debt forgiveness is not taxable. In the case of a principal residence, a special exclusion for up to $2 million of forgiven debt (11.8) is allowed through 2012; proposals have been made to extend the exclusion.

Figuring gain or loss and income from cancellation of debt on a foreclosure, short sale, or repossession.

You have gain or loss equal to the difference between your adjusted basis (5.20) in the property and the amount realized on the foreclosure, short sale, or repossession. The amount realized depends on whether or not you are personally liable for the debt that secures the property, as discussed below. Note that if the property was your home or other personal-use property and a loss is realized on the foreclosure or repossession, the loss is nondeductible. If the property was your principal residence and you realize a gain on a foreclosure, short sale, or repossession, you may be able to exclude from income up to $250,000 of the gain, or $500,000 on a joint return, under the home sale exclusion rules (29.1).

In addition to realizing gain or loss on the transfer of the property to the lender, you may also have to report income from the cancellation of the debt if you are personally liable for the debt (11.8).

Amount realized if you are not personally liable (nonrecourse debt).

If you are not personally liable on the debt secured by the property, the amount realized on the foreclosure, short sale, or repossession includes, in addition to any sale proceeds you receive, the full amount of the debt that is canceled as part of the transfer to the lender, even if the fair market value of the property is less than the cancelled debt.

You do not realize income from the cancellation of nonrecourse debt upon a foreclosure, short sale, or repossession. However, if in lieu of foreclosure (or repossession) the lender offers a discount for early repayment or agrees to a loan modification (“workout”) in which the principal balance of the loan is reduced, and you retain the collateral, the debt reduction results in income from the cancellation of debt even where you are not personally liable on the loan (31.10).

Filing Instruction

Reporting a Foreclosure or Voluntary Conveyance

You generally report a foreclosure sale or voluntary conveyance in 2012 to a creditor on Form 8949 and Schedule D if the property was held for personal or investment purposes. However, if the property was your principal residence and you have a gain, the foreclosure or voluntary conveyance does not have to be reported at all if you can exclude all of it under the home sale exclusion rules (29.1).

Foreclosures and reconveyances of business assets are reported on Form 4797.

If income from cancellation of indebtness is realized and it is not excludable under the rules discussed at 11.8, you report the taxable amount on Line 21, Form 1040.

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Amount realized if you are personally liable (recourse debt).

If you are personally liable on the debt secured by the property, the amount realized includes the smaller of the cancelled debt or the fair market value of the property transferred to the lender. This is in addition to any sale proceeds received.

Where the cancelled debt exceeds the fair market value of the transferred property, the excess must be reported as ordinary income from the cancellation of debt, unless the law allows it to be excluded. If debt secured by your principal residence is cancelled in a mortgage restructuring or foreclosure, you do not have to report the cancelled debt if you are eligible for the exclusion for qualified principal residence indebtedness (11.8). Other exclusions that may be available are the exclusions for insolvency, bankruptcy, or qualified farm debt, discussed in 11.8, or the exclusion for qualified business real estate debt discussed in 31.10.