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Analysis of Discharge of Indebtedness Income vs. taxable debt forgiveness income

Short sales and tax consequences, part 4 of 7

In this post, we will review definitions of Discharge of Indebtedness Income vs. taxable debt forgiveness income. Note that the tax consequences of foreclosure or “short sale” of a commercial or rental property will likely be much different than I will cover in this article. In this series, we are focusing on your primary residence.

You could be facing foreclosure or short sale nearly anywhere in Western Washington. Wherever you live in the state, we can help you to become aware of and informed about the potential tax consequences of a “short sale” or foreclosure.

As discussed before, the $250,000 capital gains exclusion plays a large role in whether you have taxable income on your personal residence post short sale or foreclosure.
Note that this analysis is limited to your personal residence in which you have lived for at least two years. Properties that you received as a gift or inheritance can have a different result as well, so always consult your qualified tax professional in any distress sale situation.

The National Consumer Law Center’s publication “Foreclosure Prevention Counseling”, 2009 edition, available for $60.00 at www.consumerlaw.org, covers these topics in Chapter 9, pages 147-152.

Please note that the Discharge of Indebtedness Income is not necessarily always the same as taxable debt forgiveness income.

What do we mean by “Discharge of Indebtedness Income”? The IRS considers that a taxpayer has income from discharge of indebtedness when a lender forgives some or all of a debt. If the obligation to repay a debt is forgiven, then the government looks to see if that borrowed money now constitutes income to the borrower and, if so, how much. That income is taxable like any other income the homeowner receives. Nevertheless, as described in posts five, six and seven of this blog post series, there are a number of exceptions that may mean that discharge of indebtedness may produce no taxable income at all.

Let’s review three situations in which tax might be due, but rarely result in any taxable income.

First, if there is a foreclosure and the homeowner is not liable for the deficiency, that forgiveness of the deficiency is a discharge of indebtedness income.

Second, another example is a short sale where the house sells for less than the debt and where the lender has agreed to forego any deficiency.

Third, if a loan modification is made in which the lender forgave the principal of the debt or wrote the debt down. The amount of forgiven debt would also be discharge of indebtedness income.

Note that discharge of indebtedness income is very different and distinct from capital gains income. The example that follows below is from an earlier blog post (the third of this seven part series) to help illustrate difference. Please note that it is possible for a short sale to result in both a capital gain and also a discharge of indebtedness situation. Each of (1) capital gains and (2) discharge of indebtedness must be analyzed separately and independently.
Example: A single person completing short sale-illustration of development of capital gain and discharge of indebtedness income

$50,000 original purchase price of principal residence many years ago (no funds expended on improvements during ownership so as to increase basis)
$210,000 amount on mortgage after many rounds of refinancing to “pull out equity”
-$150,000 less: short sale price when homeowner falls into financial distress
$60,000 indebtedness not paid due to short sale
$100,000 capital gain ($150,000 short sale price – $50,000 acquisition price = $100,000)
$60,000 Discharge of Indebtedness Income (but Debtor may not have to pay tax on the $60,000 amount. In later blog posts in this series, we will work through defining and differentiating Discharge of Indebtedness Income vs. taxable debt forgiveness income)
$100,000 capital gain. No taxes are due because the capital gains exclusion is $250,000 for a single person on a principal residence.

OK, so our stressed out example short sale debtor above is off the hook for capital gains tax! But will he/she escape income tax on the $60,000 discharge of indebtedness income tax? I will discuss this situation further in future posts on this topic.

Analysis of a Short Sale of a Principal Residence

Short sales and tax consequences, part 3 of 7

In this post, we will review an example of the short sale of a principal residence. In some ensuing posts, I will review the definitions of “discharge of indebtedness income” and also “taxable debt forgiveness income” to follow up on this and earlier posts that discuss foreclosures and short sales. The tax foreclosure or short sale of a commercial or rental property will likely be much different that described in this post.

The $250,000 capital gains exclusion plays a large role in whether you have taxable income on your personal residence post short sale.

Note that this analysis is limited to your personal residence in which you have lived for at least two years. As stated earlier, investment, commercial and rental properties will have a much different result than discussed here-remember to always consult your tax professional. Properties you received as a gift or inheritance can have a different result as well, so always consult your tax professional.

Discharge of Indebtedness Income is not necessarily always the same as taxable debt forgiveness income, according to the NCLC manual “Foreclosure Prevention Counseling”, 2009 edition, on page 149. The National Consumer Law Center’s publication “Foreclosure Prevention Counseling”, 2009 edition, is available for $60.00 at www.consumerlaw.org.

Example: a single person completing a short sale

$50,000: original purchase price of principal residence many years ago (no funds expended on improvements during ownership so as to increase basis)
$210,000: amount on mortgage after many rounds of refinancing to “pull out equity”
-$150,000 less: short sale price when homeowner falls into financial distress
$60,000: indebtedness not paid due to short sale
$100,000 capital gain: ($150,000 short sale price-$50,000 acquisition price = $100,000)
$60,000: Discharge of Indebtedness Income (but Debtor may not have to pay tax on the $60,000 amount. Please read later blog posts in this series as we work through defining and differentiating “Discharge of Indebtedness Income vs. taxable debt forgiveness income)
$100,000 capital gain: no tax due, because the capital gain exclusion is $250,000 for a single person on a principal residence.

Please remember that my staff and I are here to help you, regardless of whether you are facing a foreclosure or short sale, anywhere in western Washington state.

Analysis of a Foreclosure Sale

“Short sales” and tax consequences, part 2 of 7

In this post, we will review examples of foreclosure homes and some sample tax impacts of foreclosure.

Regardless of where you are facing a foreclosure or short sale, you must be aware of potential tax consequences of a short sale or foreclosure.

The $250,000 capital gains exclusion plays a large role in whether you have taxable income on your personal residence post foreclosure.

Note that this analysis is limited to your personal residence in which you have lived for at least two years.

I refer to the National Consumer Law Center’s publication “Foreclosure Prevention Counseling”, 2009 edition, that is available for $60.00 at www.consumerlaw.org, in my analysis. The relevant section is Chapter 9, pages 147-152.

Discharge of Indebtedness Income is not necessarily always the same as taxable debt forgiveness income, according to the NCLC, on page 149.

Here are some “foreclosure” examples of taxable income related to the foreclosure of a principal residence. Note that this analysis would not apply if a home you rented out as a business was foreclosed. That situation is much stickier. You should see your CPA if you have a business or rental property foreclosed.

Example 1: a single person whose residence is foreclosed upon
$50,000: purchase price of home “way back when”
+$10,000: improvements to home like a new deck and changed shower to bathtub
$60,000: basis in home
The home was refinanced many times to “pull out” equity, so the debt against the home at the time of foreclosure was $325,000.
In addition, $5,000 in “cash for keys” was paid to the single person owner after foreclosure as an incentive to move out without damaging the property.
At the time of foreclosure, the house was appraised at $400,000 by the bank.
$60,000: basis (home purchase price plus $10k improvement)
$330,000: “sale” price (e.g. amount of debt $325k + $5k paid “cash for keys”
$270,000: capital gain ($330k-$60k = $270k)
$250,000: capital gain exclusion
$20,000: capital gain
$3,000: capital gain tax due ($20k x .15 = $3k tax due)

Note: in later posts in this blog, one of five exclusions to the obligation to pay $3,000 in capital gains tax may come into play
Example 2: a single person whose residence is foreclosed upon
$125,000: home acquisition price, no improvements made to increase basis
$132,000: debt owed on home at time of foreclosure, including foreclosure fees
$80,000: home fair market value at time of foreclosure as housing prices have collapsed
$45,000: capital loss-capital losses are not taxable, thus homeowner does not owe any tax due to foreclosure as a capital tax.
However, in this example, the single person foreclosed upon could potentially owe income tax (as no capital gain tax) as discharge of indebtedness income/taxable debt forgiveness income. More on this later.
In the succeeding blog posts in this seven part series, I will cover and explain how discharge of indebtedness income can result in taxable debt forgiveness income. I will also discuss the five exceptions/exclusions to tax on the income.

Remember, we are here to help you, regardless of where you are facing a foreclosure or short sale. If you need help, please contact us.

Short sales and tax consequences – analysis of a “normal” sale

Regardless of where you live in Washington state—whether you call Federal Way, Bremerton, Tacoma, Renton, Auburn, Tukwila, Lakewood, University Place, Puyallup, or Olympia home—you must be aware of potential tax consequences of a “short sale” or foreclosure.

The $250,000 capital gains exclusion plays a large role in whether or not you will have taxable income on your personal residence after foreclosure.

Please note that this analysis is limited to your personal residence in which you have lived for at least two years.

The NCLC (National Consumer Law Center) publication entitled “Foreclosure Prevention Counseling”, 2009 edition, Chapter 9, pages 147-152, covers this subject well. This publication is available for $60.00 at www.consumerlaw.org.

For example, Discharge of Indebtedness Income is not necessarily always the same as taxable debt forgiveness income, according to the NCLC, page 149.

To understand the problem of Discharge of Indebtedness Income/taxable debt forgiveness income, let’s examine a normal (non distress) transaction to determine whether the transaction does or does not result in taxable income.

Example #1 from the NCLC:

$100,000 purchase price of home
+ $30,000 add: improvements (new deck, addition, etc.)
= $130,000 new basis

$160,000 sale price
– $9,000 less: sales expenses
= $151,000 net sale price

$21,000 capital gain
$250,000 capital gain exclusion

$0 taxable gain
$0 taxable gain tax to be paid

Example #2 – single homeowner

$20,000 purchase price
+ $30,000 certain improvements
= $50,000 new basis

$600,000 sale price
– $40,000 less: sales expenses
= $560,000 net sales price

$510,000 capital gain ($560,000 – $50,000 = $510,000)
– $250,000 capital gain exclusion
= $260,000 taxable gain

$39,000 capital gains tax payable $260k x .15 tax rate = $39,000; assuming 15% tax rate on long-term capital gain)

The previous examples contemplate a “normal” sale–not a short sale or foreclosure.

In a future post, I will provide some examples of foreclosure/short sale operation.

What oversight actions has the Consumer Financial Protection Bureau taken recently

The Consumer Financial Protection Bureau (CFPB), an organization created by the Dodd-Frank Wall Street Reform and Consumer Protection Act, has recently announced new rules to regulate and oversee some of the bigger agencies in the debt collection and credit reporting industries.

The CFPB was given the power to regulate non-bank financial entities by the Dodd-Frank Act, but has faced opposition since its inception. This resistance comes from various lobbying groups and a number of legislators who believe that regulation of such industries should not be part of the government’s jurisdiction.

Despite the opposition, the CFPB has pushed ahead to announced oversight rules that will apply to debt collection firms that earn more than $10 million per year and to consumer reporting agencies that make more than $7 million per year.

According to numbers from the CFPB, this will include about 175 debt collection firms, or four percent of all debt collectors in the U.S. Four percent may seem like a small margin, but they are responsible for collecting 63 percent of all debts in the U.S.

Along with the 175 debt collection firms, about 30 consumer reporting agencies will also be affected by the new rules. That is about seven percent of such agencies nationwide. Once again, seven percent is not a huge amount, but these consumer reporting agencies are responsible for collecting 94 percent of receipts from consumer reporting activities.

The CFPB estimates that its newest proposed rules will impact the lives of millions of Americans. At present, the CFPB reports roughly 30 million Americans have debts under collection.

In complaints filed with the Federal Trade Commission (FTC) and elsewhere, many of those have complained that debt collectors illegally tried to collect on debts. Among those illegal collection attempts were efforts to recover debts that were legally discharged in bankruptcy court.

It is important to note that debts discharged by bankruptcy cannot legally be collected.

Once the new rules go into effect, Americans might see better behavior from the non-bank financial institutions that they deal with on a daily basis. Some commentators, however, are less than optimistic about the potential impact of the rules.

After all, laws already in effect (including the Fair Debt Collection Practices Act and the Fair Credit Reporting Act) are supposed to protect consumers against many abuses from debt collectors and credit reporting agencies.

While the CFPB has the authority to oversee financial entities, it does not have the power to pass or enforce laws regarding this industry, and so may end up having a limited net effect on the way consumer debt and credit is handled in the U.S.

Many experts believe that we may be headed for another recession. Don’t enter a second recession with mountains of debt. I can help you to understand the options available to you for dealing with your debts. I am sure that I can be of assistance to you, to a family member, or to a friend as we all know people experiencing trouble these days even if we are not experiencing our own financial troubles. Please do not hesitate to make contact with me. I emphasize courteous and discrete consultations that fill your time with useful information. The impact to your life after an in-person consultation with me may be substantial, and life-long. You will enjoy a new peace of mind and a fresh hope for the future with a new roadmap for financial success that we develop together. You can contact my scheduler through our website for your free 30 minute consultation. If you wish, you may schedule your free 30 minute consultation by phone by calling us at 253-383-1001 Monday through Thursday from 9:00 AM until 5:45 PM, and on Friday from 9:00 AM until 12 noon.

Student Loans: Should I borrow the money? What is a Parent Plus Loan?

As I approach my 19th year in the practice of law, I often ponder the risks of assuming large student loans. I took the risk, and I successfully repaid my student debt. Others have not been so lucky.

I signed my first student loan promissory note on September 6, 1985. I finished undergraduate studies with a loan debt of $11,000. My total borrowings topped out at just short of $60,000.00 in 1993 following law school. It was a surreal number to me. I found it depressing. If I recall correctly, the payments were over $750 monthly, and started in January,1994. I struggled at first as my first job as a lawyer did not pay very much. I bumped along, scraping, scrimping, and saving (and keeping my old car running) for just about two years, until 1995 when I was able to “consolidate” to a payment of some $450 monthly plus an “unconsolidatable” loan that I paid $60 monthly on the side of for a total of about $510 monthly. This was a princely sum for a 27-year-old with an old, dying car and no outside family help.

Essentially, I paid my last student loan payment in July 2010. Some sixteen and one-half years later.

I have always been a bit entrepreneurial, In 1996, I was able to start my own law practice. From its inception, it has always done pretty well. Others have not been so lucky. Many of my friends have struggled with student loan payments.

How would my road be different today if I was a graduating high school student?

I don’t know if I would have even gotten so far today as tuition is higher and some of the student loans I was able to take out are not as available. Many of the loans offered today are Parent Plus loans, in which the student loan lenders try to get the parents of a student to sign up for the student loan. I don’t know if my parents would have been so willing to sign student loan notes for me in the amount required to get through four years of private undergraduate education. Also, with tuition hikes, the $10,000 I borrowed to get through my undergraduate program may be equivalent to borrowing $30,000 today. Would my parents (both hardworking people with high-school educations ) have been willing to sign up for $30,000 (in today’s dollars) of parent-obligated “plus loans”?

I likely would have had to attend a less expensive school under today’s situation, other than the Whitworth College (a private Presbyterian affiliated college in Spokane, WA) that I attended. I greatly benefited from my time at Whitworth. I believe that my educational experience at some other school would not have had the same qualities that Whitworth provided me. I can safely say that under today’s situation, my trajectory would have be different now than the one I was able to take.

If you are a parent, and your child is extremely motivated and a high achiever, I would probably step up and sign up for an appropriate amount of Parent Plus student loans as a last resort. However, if your child is a bit unsure of his/her direction, I suggest that you avoid the Parent Plus loan option. In the case where your child is less focused or not a high achiever, you are better off taking out a home equity loan (if you have any home equity) to pay for their education rather than taking out Parent Plus loans. The reason I recommend this approach is because even if you end up in financial trouble, the home equity line of credit can potentially be discharged through bankruptcy should you lose your home, whereas the Parent Plus loan is less dischargeable in bankruptcy.

If you are a child and are considering asking your parents to sign up for a Parent Plus loan for your benefit, all I can say is that you better be “on target” with your education. If you’re reading this blog, there’s a very good chance that you are aiming pretty well.

Seriously, for a young person to make good on their promise to their parents in return for their financial support through a Parent Plus loan, you need to get in, get great grades, graduate, and get to work. Do not screw your parents financially by changing your major five times, and by partying while you bring home a string of C’s, D’s and the occasional F. You need to decide on your major (or at least your department) before you show up for the first day of college as a freshman, and you need to stick with it even if you decide you might “want to go in a different direction”. You do not have the right to ask your parents to obligate themselves unless you are giving 110%. If you are not achieving top honors (baring some sort of learning disability) while asking your parents to sign up for Parent Plus loans, you are insulting your parents. Parent Plus loans did not exist when I was in college, but during my first couple of years at school, my parents did pay for some of the tuition. My way of honoring their commitment was to graduate summa cum laude which means “highest honors”. I was 5th in GPA in my college graduating class and finished with a 3.91 Grade Point Average. I received one “B” grade in my freshman year and two in my senior year. Every other grade was an “A”.

For what it is worth, that is my story. If you are a parent and your child does not have a commensurate level of committment to educational and study dedication, then you have the right to say “no” to a Parent Plus loan when asked by your child.

If you are a child and you do not intend to excel and be at the top of your class and department, you have no right to ask your parents to so obligate themselves to a Parent Plus loan, unless of course your parents are so wealthy that the Plus Loan is of no financial consequence to their long-term economic position.

Thank about it. Student loans are only for people ready to give a 110% effort towards being a student. There is a reason they are called student loans, and not called “play time, find myself loans.” Student loans are serious. If you take one out, you need to be serious about your career based on the education that you are buying with your student loan.

An update on the state of Washington’s economy

This past Tuesday, House Democrats presented their plan to fix the state’s budget shortfall. They have proposed relying on $400 million in delayed payments and reduced support for local governments, while mainly protecting basic education from further cuts.

The House Democrat’s plan saves over $890 million without asking voters for a sales tax increase, which was initially suggested by Gov. Chris Gregoire. On top of this, the Democrats propose to leave $504 million in reserves. The proposal does, however, open the door to higher local taxes.

The largest savings come from delaying the $405 million in payments to schools until the next budget cycle. That budget cycle begins in July of next year. Their proposal also calls for $65 million in cuts to higher education, and $224 million in cuts to health care and human service programs.

Democrats suggest decreasing distributions to local governments by $82 million. This will include support for criminal justice programs, along with the elimination of a sales tax credit for rural counties. To make up for that, the state would essentially give local governments authority to make tax increases without a public vote.

Another $18.1 million will come from the elimination of another tax break. This tax break allows out-of-state banks the ability to claim the break on interest earned on first mortgages. The plan also accounts for nearly $54 million in fund transfers, including more than $37 million in unspent agency money being returned to the state’s general fund.

The Democrats are looking to save an additional $130 million in other areas, including reductions to the Department of Corrections’ chemical dependency treatment and community supervision programs.

In a statement on Tuesday, Gov. Gregoire called the budget proposal “a good start”, stating “I’m pleased this budget leaves a sizable ending fund balance as we must continue to plan for unforeseen circumstances.”

Senate Democrats are expected to unveil their budget proposal next week. The 60-day legislative session ends March 8.

An update on Washington Mutual’s bankruptcy reorganization plan

Washington Mutual Inc. has reached an agreement with previously objecting creditors that could lead to an approval of its latest bankruptcy reorganization plan.

This morning, a hearing in WaMu’s bankruptcy was delayed several hours as attorneys worked towards obtaining a settlement involving creditors who bought certain WaMu securities. The WaMu securities in question were converted into stock when regulators seized WMI’s flagship bank in 2008 and sold WaMu’s assets to JPMorgan Chase.

The securities investors voted against WMI’s plan, because they faced far less recovery as stockholders than they would as debt holders. This raised doubts as to whether WaMu could win court approval.

In exchange for withdrawing their “no” votes, the investors will receive $18 million from JPMorgan and an unsecured claim of about $618,000. On top of that, these investors will be able to seek reimbursement of legal fees, up to $15 million.

I will post additional updates as developments in the case unfold.

What is the state of Washington’s economy?

A recent story presented by KOMO News stated that as of February 9, 2012, Washington State’s budget shortfall is down to $500 million. The state’s economy is stabilizing and showing signs of growth as people rely less on state services.

Numbers released last Thursday by the state’s Economic and Revenue Forecast Council showed $96 million in extra revenue and an additional $340 million in expected savings from less reliance on state services. Prior to this report, state legislatures had been looking at about a $1 billion shortfall.

According to Steve Lerch, the U.S. economy has had higher job growth than anticipated. He also stated that Boeing manufacturing output, growth in the software sector, and strong exports have placed the state in a “decent” position.

Lerch still has his reservations about celebrating, though. He feels that due to our country’s financial situation compounded by the economic crisis overtaking Europe and the slowdown in Asia creates a variety of risks that Washington state needs to continue to monitor.

With these risks in mind, state budget officials are looking at ways to cover more than just the current shortfall. They hope to retain a buffer of approximately $600 million in case the state economy struggles again.

House Republicans plan to release their proposal for the budget by tomorrow, and the Democrats have promised to release their ideas next week.

Any new developments on the national mortgage settlement?

According to the National Mortgage Settlement web site, 49 state attorneys general and the federal government reached agreement to settle a long-running dispute with the country’s five largest loan servicers: Ally/GMAC, Bank of America, Citi, JPMorgan Chase, and Wells Fargo. The settlement will provide as much as $25 billion in relief to distressed borrowers and direct payments to states and the federal government.

The agreement settles state and federal investigations finding that the country’s five largest loan servicers routinely signed foreclosure related documents outside the presence of a notary public and without really knowing whether the facts they contained were correct. Both of these practices violate the law. The settlement provides benefits to borrowers whose loans are owned by the settling banks as well as to many of the borrowers whose loans they service.

If you are a home owner, and your loan was serviced by one of the five loan servicers listed above, the settlement may apply to you. However, eligibility may take some time to determine. The agreement will be performed over a three year period.

Another point to consider is that, the agreement does not affect any individual’s rights. A consumer may still bring an individual action, be a part of a class action, or seek further review/relief from the Office of the Comptroller of the Currency (OCC).

Additionally, loans owned by Fannie Mae or Freddie Mac are not impacted by this settlement. The FAQ page on the site contains links to both sites to help you determine if your loan is owned by either Fannie Mae or Freddie Mac.

The National Mortgage web site contains quite a bit of useful content, including a list of Frequently Asked Questions about the agreement, an executive summary of the agreement, and even a list of contact information for the 49 participating state attorneys general offices.

Here is the information for Washington state residents:

Washington Attorney General Rob McKenna
1125 Washington St. SE, PO Box 40100, Olympia, WA 98504-0100
(360) 753-6200
http://www.atg.wa.gov/

This is a complex agreement. I may be able to help you understand your situation; I can certainly help you by discussing certain tradeoffs and options concerning home ownership and bankruptcy. You can contact my scheduler through our website for your free 30 minute consultation. If you wish, you may schedule your free 30 minute consultation by phone by calling us at 253-383-1001 Monday through Thursday from 9:00 AM until 5:45 PM, and on Friday from 9:00 AM until 12 noon.