The IRS has responded to the growing subprime mortgage crisis by setting up an information center on its irs.gov website to help struggling homeowners make better decisions that take into account the tax impact of their actions. A group of FAQs, with worksheets and examples to figure debt cancellation income and gain on foreclosure, forms its centerpiece.

Also notable within both the FAQs was the IRS's advice to homeowners to consider the tax consequences before foreclosure, to possibly work out any resulting tax liability through offers-in-compromise and installment agreements and to realize that certain issues may be too complex without "the assistance of a tax professional."

Cancellation of Debt

If a lender forgives any portion of the principal of a mortgage loan there is a cancellation of debt which generally results in taxable income. However, the IRS highlights that there are exceptions when this is not taxable:

• A bankrupt taxpayer does not have income on debts discharged through bankruptcy.
• An insolvent taxpayer does not recognize income on some or all of the cancelled debt. A taxpayer whose debts exceed liabilities is insolvent. The taxpayer's basis in the property may be reduced.
• Cancellation of qualifying farm debts is not income.
• On a foreclosure, a taxpayer with a nonrecourse loan (the borrower is not personally liable) does not have cancellation of debt income, although there may be gain from the foreclosure.

Gain from Foreclosure

The foreclosure of property is treated like a sale. If the property's fair market value (or nonrecourse debt) exceeds its basis, the difference is taxable gain. The gain is excludable up to $250,000 ($500,000 for joint filers) under Code Sec. 121, if the property was owned and used as the principal residence for two of the previous five years. Any remaining gain is taxable as capital gain and should be reported on Schedule D. Any losses, however, are not recognized.

Similarly, on a foreclosure, if the debt on the property exceeds its fair market value, the difference is cancellation of indebtedness income that must be reported as ordinary income on Form 1040. But there is no taxable income if the debtor is insolvent or bankrupt.

Offers-in-Compromise

If the debtor has taxable income and cannot pay the tax due in full, the IRS suggests that the debtor consider an installment agreement with the agency. Alternatively, for taxpayers with few assets, the IRS "in some cases" may be willing to enter into an offer-in-compromise that will relieve the taxpayer of some of the tax.

Legislative Relief

President Bush has proposed changes to the Tax Code that would ensure cancelled mortgage debt on a primary residence is not counted as income and Congress is currently considering the proposal. The Senate Finance Committee is expected to mark up tax legislation the week of September 17.

Our office will monitor the progress of this legislation and keep you updated. Please don’t hesitate to call our office if you would like additional information about the tax consequences of foreclosure.

(IR-2007-159, IRS Website)