Tag Archives: Capital Gain

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 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.