Taxation of Cancelled Debt arising from Foreclosure of Real Property

Thumbnail image for Foreclosure.jpgWhile the United States economy slowly improves, foreclosure rates continue to remain high. According to RealtyTrac, there were nearly 127,000 foreclosures filed in May 2015 and New Jersey had one of the highest rate of foreclosures in the nation. In fact, one in every 483 housing units is being foreclosed. New Jersey experienced a 197 percent year-over-year increase in bank repossessed properties, which was the highest increase in the nation. Additionally, Atlantic City, New Jersey had the highest foreclosure rate among metro areas in the country, with one in every 230 housing units experiencing a foreclosure filing.

However, many of our clients are pleasantly surprised to learn that cancelled debt on a taxpayer’s qualified principal residence and business may not be income subject to tax. The Mortgage Forgiveness Debt Relief Act of 2007 (the “Act”) allows taxpayers to exclude the discharge of debt from a principal residence and real property business indebtedness if two criteria are met:

(1) The discharge cannot occur pursuant to a title 11 (bankruptcy) case; and

(2) With regard to amounts excluded due to insolvency (“Insolvency Exclusion”):

(i) The Insolvency Exclusion takes precedence over any claim under the business property exclusion; and (ii) The taxpayer expressly elects to apply the Insolvency Exclusion in lieu of the principal residence exclusion.
Under the Act, the Insolvency Exclusion permits a taxpayer to exclude any amount by which a taxpayer is insolvent. Insolvency is defined as “the excess of liabilities over the fair market value of assets. With respect to any discharge, whether or not the taxpayer is insolvent, and the amount by which the taxpayer is insolvent, shall be determined on the basis of the taxpayer’s assets and liabilities immediately before the discharge.”

For example: A taxpayer accrues credit card debt in the amount of $5,000 and a credit card company forgives the entire amount of debt. Prior to cancellation, the taxpayer incurs $15,000 in liabilities and $9,000 in assets, resulting in insolvency in the amount of $6,000. As such, the taxpayer may exclude the $5,000 debt forgiven by the credit card company under the Insolvency Exclusion because $6,000 is greater than $5,000.

With regard to the principal residence exclusion under Section 108 of the Internal Revenue Code (“IRC”), gross income does not include any amount which would be includible in gross income by reason of discharge (in whole or in part) of indebtedness by the taxpayer if the indebtedness discharged is qualified principal residence indebtedness which is discharged before January 1, 2014. The principal residence exclusion may only be used toward debt that was discharged between the years 2007 through 2014. Taxpayers who file a joint or individual tax return are eligible for the Principal Residence Exclusion, up to $2,000,000. Married taxpayers who file a separate tax return are eligible for the Principal Residence Exclusion up to $1,000,000.

QualificationSection 108 of the IRC provides that the Principal Residence Exclusion cannot be applied to the discharge of a loan if the discharge is on account of services performed for the lender, or “any other factor not directly related to a decline in the value of the residence or to the financial condition of the taxpayer.”

Additionally, if a loan is discharged, in whole or in part, and only a portion of the loan is qualified principal residence indebtedness, the Principal Residence Exclusion “shall apply only to so much of the amount discharged that exceeds the amount of the loan (as determined immediately before such discharge) which is not qualified principal residence indebtedness.”

Eric Browndorf, Esq. is a partner and Chairman of Cooper Levenson’s Bankruptcy & Financial Restructuring practice group. Eric has practiced exclusively in banking, creditor’s rights, bankruptcy and commercial litigation since 1984. Eric may be reached at 609.572.7538 or via e-mail at ebrowndorf@cooperlevenson.com. Eric is licensed to practice law in New Jersey, Pennsylvania and Kentucky.

Michael Salad, Esq., LL.M. is an associate in Cooper Levenson’s Business & Tax and Cyber Risk Management practice groups. He concentrates his practice on estate planning, business transactions, mergers and acquisitions, tax matters and cyber risk management. Michael holds an LL.M. in Estate Planning and Elder Law. Michael is licensed to practice law in New Jersey, Florida and the District of Columbia. Michael may be reached at 609.572.7616 or via e-mail at msalad@cooperlevenson.com.

Date Published: February 7, 2017


Written by: Michael Salad

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