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Do you think homedebtors are ready for their California tax bill on forgiven debt? That HELOC will get them.

There’s a fog upon L.A.
And my friends have lost their way
We’ll be over soon they said
Now they’ve lost themselves instead.

As the fog clears over our housing market, those who have lost their debts will find their debts are seeking them.

Patrick.net recently featured this article found on the California Franchise Tax Board’s website: Foreclosures and the next wave: taxes due on canceled debt

… If their lender forecloses on their homes, or accepts an amount less than the loan balance from sale of the home, it may result in taxable gain to the homeowner. The type and treatment of the gain will depend on whether the mortgage is considered non-recourse or recourse debt.

In California, purchase money mortgages, which are mortgages where the borrowed funds are used to purchase the house, are generally treated as non-recourse debt. If the bank forecloses on a non-recourse mortgage, then the homeowner is treated as having sold the home for the amount of the outstanding debt. The difference between the outstanding debt and the homeowner’s adjusted basis in the house is considered a gain or loss on the sale of the home. If the home is the taxpayer’s principal residence, where they have lived for at least two of the past five years, the gain may be eligible for the gain exclusion on the sale of a principal residence. If the foreclosure results in a loss, the loss may not be taken since it resulted from the sale of a principal residence.

With the refinance craze and HELOC boom of the 00s, how many purchase money mortgages exist? In 2006, over 80% of loan originations were refinances; consequently, only the most frugal or those who bought at the peak still have purchase money mortgages. The bulk will be recourse.

If the mortgage is recourse, such as a non-purchase money mortgage or a refinanced mortgage, any foreclosure may result in a gain on the sale of the house, and/or cancellation of debt income. The difference between the fair market value of the house and the homeowner’s adjusted basis will result in a gain or loss on the sale of the home. To the extent the outstanding debt exceeds the fair market value of the house, the amount is treated as cancellation of debt income. Any gain on the portion treated as the sale of a personal residence may be eligible for the exclusion on the sale of a principal residence; however, as discussed above, the loss may not be taken on the sale. The portion that is treated as cancellation of debt income is taxed as ordinary income – subject to ordinary income tax rates. Your clients with canceled or forgiven mortgage debts may receive a Form 1099-C from the lender and will be expected to pay federal and state tax on the canceled amounts, at the ordinary income tax rate.

For example, if the homeowner has a non-recourse mortgage with an outstanding balance of $250,000, and has an adjusted basis of $100,000, the house has a fair market value of $200,000. If the homeowner’s lender foreclosed on the mortgage, the homeowner would have taxable gain of $150,000 ($250,000 less $100,000). If the mortgage had been recourse, the homeowner would have gain on the sale of the home of $100,000 ($200,000 less $100,000), and cancellation of debt income of $50,000 ($250,000 less $200,000).

Many renting-former-owners who have either gone through foreclosure or sold short believe they have no further responsibility to the debt. The lenders are gearing up for collection, but once they give up and begin writing down the debts, they will issue 1099s, and then the State of California will look to collect. This debt is going to linger in one form of collection or another for decades.

Tax on this seemingly “phantom” type of income is due whether the bank forecloses on the mortgage, or allows a “short sale” (allowing the defaulter to sell the house at below cost, and accepting the proceeds as payment in full). A short sale is preferable to a foreclosure only in the sense that it does less damage to the homeowner’s credit rating. The difference between the amount owed to the lender, and the amount received is still considered canceled debt, and taxed at the ordinary income rate. Relief of debt is considered income because the bank gave the buyer cash to purchase the home when it issued the mortgage. This cash was not taxable because it was a loan, and the buyer promised to repay it. When the loan is forgiven or canceled, it becomes income in that year since the buyer will no longer repay it.

You must admit, the logic of the tax position is inescapable. Nobody who took out HELOC money and spent it was thinking about setting aside tax reserves.

There are a couple of options for your clients who are caught in this situation:

• Bankruptcy: Debts discharged in bankruptcies are generally not considered debt-cancellation income.
• Insolvency: Tax will not be assessed on the phantom debt-cancellation income if your client can prove insolvency existed when the debt was discharged. Your client must prove that all assets totaled less than all debts.

If you have clients who have exhausted their options and cannot pay the additional tax on the phantom income they “accrued” through debt cancellation, remember to look into our offer-in-compromise and payment arrangement programs.

You may also want to check out the IRS new Web page devoted to foreclosure tax relief, and related FAQs.

Bankruptcy or insolvency? Those don’t sound like appealing options. Of course, most debtors will claim insolvency and hope they are never asked to prove it, and many, if not most, of those will get away with the deception.