Article: Foreclosure and the Threat of Taxable "Phantom Income"

December 2007

Foreclosure and the threat of taxable "phantom income"

Recent federal legislation provides relief for some people who have lost their home, but the specter of large artificial increases in their taxable income continues to be a hazard for many

Updated January 7, 2008

For those who watch their adjustable mortgage payments rise out of reach, who lose a job or fall victim to illness, or who otherwise struggle to pay their bills, losing one’s home can feel like hitting bottom. But one more financial indignity may await: unexpected “phantom income” and no corresponding source of funds to pay a significantly higher income tax obligation.

This predicament stems from an IRS policy that treats canceled debt as income, even if the taxpayer has nothing tangible to show for it. Subject to important exceptions (discussed below), if you borrow money from a commercial lender, and the lender later cancels or forgives the debt as part of a foreclosure, short sale, or deed in lieu of foreclosure, you may have to include the canceled amount in your taxable income. The lender is generally required to report the amount of the canceled debt to you – and to the IRS – on a Form 1099-C (Cancellation of Debt).

Many taxpayers who have lost their homes gained some much-needed relief in December, when Congress passed and President Bush signed into law the Mortgage Forgiveness Debt Relief Act of 2007. The new law provides a permanent exclusion from taxable income for cancellation of debt, where:

the cancellation occurs between January 1, 2007, and December 31, 2009;
the debt is secured by a principal residence; and
the debt was incurred in the acquisition, construction, or substantial improvement of the principal residence.

Exceptions. For many taxpayers, this is very welcome news. Prior to passage of the Debt Relief Act, cancellation-of-debt income was excluded from the taxable income of most borrowers only if they filed bankruptcy or were insolvent when the debt was canceled, or if the loan that was canceled was a "non-recourse" loan (not common in residential lending).

However, for taxpayers whose debts were canceled before 2007, were secured by property other than their principal residence (e.g., a vacation home or investment property), or were used for purposes other than acquisition, construction or substantial improvement of the principal residence, the Debt Relief Act probably provides little relief.

Still at risk is that large group of people who refinanced their homes and used part of the proceeds for purposes unrelated to the property. Here is a simple example:

In 2004, John and Mary bought a new principal residence for $250,000. They made a $25,000 down payment and borrowed $225,000 from their bank.
Within two years their home had appreciated substantially, and they were able to refinance their mortgage with a new loan of $375,000.
- They used $220,000 of the new loan to pay off the old mortgage.
- They remodeled the kitchen and made some other major improvements to the home, spending about $75,000.
- The remaining $80,000 was used to pay off some consumer debt, purchase a new car, and save for their son's college expenses.
Then John lost his job, and they were unable to keep up with their financial obligations. The lender foreclosed, sold the home for $300,000, and issued a Form 1099-C that showed cancellation-of-debt income of almost $100,000 (the difference between the $300,000 sale price and the nearly $400,000 mortgage balance).
John and Mary were able to reduce their "phantom income" by $20,000, since that portion of the canceled debt was used to improve their home.
The remaining $80,000 was added to their adjusted gross income. Barring bankruptcy or the ability to meet the criteria for insolvency at the time the debt was canceled, they would be left with a much higher tax bill and no corresponding income to pay it.

What to do. If a lender has canceled a loan for which you were the borrower, and you receive a Form 1099-C or other notice of taxable income associated with cancellation of debt, immediately contact your Schmidt Westergard & Company tax professional. A thorough examination of your specific situation may help you avoid a painful increase in your tax bill stemming from phantom income.

Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market.