Debt Free

A deed in lieu of foreclosure is a legal proceeding where a homeowner transfers all ownership in their property to the lender to avoid foreclosure. They transfer the deed and poof!! No more foreclosure. Now the lender holds the property and the previous mortgage holder has no more mortgage debt (on that property). Obviously the value of the property must exceed the level of debt for this scheme to work.

Generally there should be a written communication from the mortgage holder to the lender expressing a desire for such a proceeding. This prevents the mortgage holder from later experiencing buyers (sellers?) remorse, deciding they didn’t get such a good deal after all, and making a claim against the lender.

Typically the lender will require every avenue toward sales of the property be exhausted before they’ll consider a deed in lieu of foreclosure alternative, so don’t get your hopes up yet. These types of transactions are becoming more difficult to get approval for with many lenders in the last year. The lenders feel they are too one sided and there are too many problems they may have to deal with.

How does giving up your deed in lieu of foreclosure affect you for tax purposes? As usual the IRS has a say in the matter, and you could have some tax liability associated with the transaction; once again, the boys and girls over at revenue giving you a bit of kick when you’re down, so to speak. From their side of the coin, it looks like the cancellation of debt that occurs is the same as income, and that must be declared. In many cases, there ways to eliminate some or all of the tax liability associated with giving up your deed in lieu of having your home foreclosed upon.

If you have debt forgiven in a DIL, you will receive a form 1099a from your pals at the IRS. The actual title of the form is “Acquisition or Abandonment of Secured Property”. As the title implies it deals with the tax consequences of what amounts to abandoning your property.

Note that the 1099a for a debt in lieu is not the same as if you actually had your debt forgiven through the foreclosure process. In that case you’d receive a Form 1099c “cancellation of debt”. With a 1099a for the DIL, if, for example, you had a property that you owed $250,000 on and you traded the deed to avoid foreclosure, you would owe the difference between the fair market value and the outstanding debt. According to the IRS, this applies if the amount in box 4 (fair market value) is less than the amount in box 2 (debt owed to the lender(principal only)).

Here’s the explanation according to the IRS:
“When you borrowed the money you were not required to include the loan proceeds in income because you had an obligation to repay the lender. When that obligation is subsequently forgiven or the property is abandoned or foreclosed, the amount you received as loan proceeds is reportable as income because you no longer have an obligation to repay the lender and/or you may be unable to pay the lender. The lender is usually required to report the amount of the canceled debt to you and the IRS on a Form 1099-A, Acquisition or Abandonment of Secured Property, or Form 1099-C, Cancellation of Debt.”

In the eyes of the IRS you receive proceeds through this process, as you no longer have a liability (the outstanding balance on your mortgage) on your personal balance sheet. The value of this cancellation is viewed as compensation, so you are taxed at the income tax rate. To add insult to injury, this income could very well push you into a higher tax bracket, making you have a greater tax liability than you would have otherwise.

This is definitely an area where you want the advice of a qualified tax attorney or accountant. The professional you choose should have expertise in this particular area of tax and real estate. The last thing you want is to trade a foreclosure on your house for a tax problem with the IRS.

How to eliminate some or all of your tax liability when proceeding with a deed in lieu of foreclosure –
One way you may be able to get around owing more tax is if you can prove that you’re insolvent, or you can declare bankruptcy. To prove insolvency or bankruptcy to the IRS’s satisfaction you have to fill out IRS form 982 (yes, another IRS form).  As pursuant to the terms of the Mortgage Forgiveness Debt Relief Act of 2007 that went into effect in December, the first $2 million of the primary mortgage amount is immune from tax liability should it be forgiven. Note that the Mortgage Forgiveness Debt Relief Act only applies to your primary residence, as defined in IRS section 121.

Once again, this is definitely an area where you want the advice of a qualified tax attorney or accountant (I’m neither) before deciding on your best course of action.

Hopefully none of this applies to you and you’re (more or less) happily making your mortgage payments on time; foreclosure is not in your future. Let’s just hope the price of gas doesn’t keep going up and you have to decide between your mortgage or filling your gas tank.