I Received a 1099 from My Home Equity Lender-
What Steps do I need to Take?
Tax Consequences of
Foreclosure-with a HELOC
By: Beth S.
Cohn
It is common for homeowners to have a house that is "upside down",
many with first and second mortgages. Houses that were
purchased a number of years ago appreciated rapidly in a short
period of time and it was easy to pull on the home's equity by
securing an equity line of credit. That equity may have been used
for many purposes, including home improvements, constructing a
swimming pool, funding college educations, purchasing new cars or
boats, paying off credit cards and investing in businesses.
These loans are second loans behind the original purchase money
loan and are commonly called Home Equity Lines of Credit or Home
Equity Credit Lines ("HELOCs").
When homeowners are deciding if they can afford to keep their house
by continuing to carry their first mortgage and their HELOC, they
need to consider whether or not the HELOC will be covered under
Arizona's anti-deficiency statutes and what the tax consequences
are of a foreclosure or short sale.
In our recent article "I Received a 1099 from My Lender- Now
What?" we discussed the tax consequences in Arizona of a
foreclosure or a short sale when the loan is the original
purchase money loan and there is no HELOC. This
article will examine the tax consequences of a foreclosure when the
personal residence has both its original purchase money loan
and a HELOC. It is important to
note, that a refinance of an original purchase money loan with or
without a HELOC is not covered in this article.
What is the Difference between a Recourse and a
Nonrecourse Loan?
Under Arizona law, if the loan is considered a "purchase
money" loan, the house is on 2 ½ acres or less and
is a single one family or two family dwelling, the lender cannot go
after a deficiency (the shortfall between the outstanding debt and
the sales price at a foreclosure sale or in a short sale) against
the homeowner. A purchase money loan is defined as using the
proceeds of the loan to purchase the residence. In Arizona, this is
what is frequently referred to as the "anti-deficiency"
rules.
With
the anti-deficiency rules, the homeowner walks away and does not
owe the lender any balance after the foreclosure. The
anti-deficiency rules do not apply to HELOCs that
are used for purposes other than making improvements to the
home.
The
anti-deficiency statutes generally do not apply to
a HELOC. If the HELOC is not considered a purchase money loan
under Arizona law, the homeowner has liability to the lender and
the lender can proceed against the homeowner for a deficiency on
the HELOC. Even after a foreclosure by the first lender, the
lender on the HELOC can still sue the borrower for the
outstanding amount of the HELOC loan.
How Does a HELOC Impact How Much Tax is Due on a
Foreclosure?
As a general principle of tax law, when a lender forgives a
recourse debt, the amount forgiven is included in income as
cancellation of debt income, unless an exception
applies.
Exception 1: Mortgage Forgiveness Debt Relief Act (the "Act")
applies. The Act provides that homeowners can exclude from
income the discharge of "qualified principal residence
indebtedness" on the foreclosure or restructure of such debt on a
personal residence of up to $2 million (if married) or $1 million
(if married filing separately). A single person is not
directly addressed by the law. The Act only applies to debt
incurred to acquire, construct or substantially improve any
"qualified residence" and certain loans to refinance such
debt. HELOCs are not "qualified principal residence
indebtedness" if they are not used to substantially improve
the taxpayer's residence. Therefore, the amount of
the income recognized from the forgiveness or discharge of a HELOC
is not excluded from income.
Exception 2: The homeowner qualifies for another exception to the
inclusion of income from the cancellation of the debt, such as
insolvency or discharge of debt under bankruptcy cases. Many
taxpayers may assume that they are insolvent for the insolvency
exception if they believe that their liabilities exceed the fair
market value of their assets. This includes IRAs and
retirement plans. This determination must be made by a
qualified tax or legal professional.
The
following illustration details the tax consequences of a
foreclosure or a short sale of a personal residence in Arizona
where there is both an original purchase money loan and a HELOC.
The assumptions are that the property is the owner's primary
residence, the Arizona anti-deficiency rules apply to the first
loan, but not to the HELOC.
EXAMPLE:
Original
purchase price was $200,000, with no money down. House
appreciates to $300,000. The owner obtains a HELOC for
$50,000 to pay off credit cards. The house is now worth
$200,000. The owner falls behind in the payments and the
lender forecloses on the first loan for the balance of the loan,
which is $190,000.
Bid price
at the foreclosure sale is $190,000, and there is a nondeductible
loss on the sale of $10,000, as to the first loan.
The
lender decides not to proceed against the owner on the HELOC and
forgives the balance of $50,000. The homeowner has $50,000 of
cancellation of debt income. The Act does not apply.
The homeowner would need to qualify for another exception, such as
insolvency or discharge of debt under bankruptcy laws. If
they do not qualify, then the cancellation of debt income is
included as income.
Reporting
Requirements
When a
HELOC is discharged on the lender's books, the lender is required
by the IRS to issue a 1099-C for the forgiven portion of the loan
to the borrower. Assuming that no portion of the discharged
HELOC is used to make improvements on the residence, the full
amount of the discharged debt is generally includable in income
unless the borrower qualifies for the insolvency exception or the
bankruptcy exception. Form 982 should be filled out to claim any
exceptions and filed with the Form 1040 for the applicable
year.
Conclusion
These issues are complex and each loan and each situation is
different. Do not automatically assume that the amount of a
loan that is discharged on a personal residence is excluded from
taxable income. In many cases, HELOCs that are forgiven or
discharged by lenders are reportable as income from cancellation of
the debt unless an exception to reporting applies. There may
be different tax consequences depending on the value of the
residence and additional questions may arise if the existing loan
is a refinance of an original purchase money loan. It is
highly recommended that you obtain an analysis by a qualified CPA
or attorney.
About the author: Beth S. Cohn is a shareholder at the Phoenix
law firm of Jaburg Wilk. She chairs the business law
department and is a State Bar of Arizona certified tax specialist
and a CPA. Beth can be reached at bsc@jaburgwilk.com or
602.248.1030.
This article is not intended to provide legal advice and
only relates to Arizona law. It does not consider the scope
of laws in states other than Arizona. Always consult an
attorney for legal advice for your particular situation.
IRS CIRCULAR 230 DISCLOSURE: To ensure compliance with
requirements imposed by the IRS, we inform you that, to the extent
this communication addresses any tax matter, it was not written to
be and may not be relied upon to (i) avoid tax-related penalties
under the Internal Revenue Code, or (ii) promote, market or
recommend to another party any transaction or matter addressed
herein.
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