You Just Lost Your House

Now here's your tax bill

By Kaye A. Thomas
Posted October 5, 2007
Updated December 21, 2007

Pending legislation would provide tax relief in foreclosures.

You don't have to report income when you borrow money. You have more cash, of course, but you also have an obligation to repay. What happens if the debt obligation is cancelled without repayment? At that point you're ahead of the game, in theory at least: you received cash and you no longer have to repay, so you have to report cancellation of debt income.

Rules imposing tax on COD income have been with us a long time, but the current mortgage crisis highlights a problem with those rules. People that go through foreclosure are likely to be financially distressed. They stretched to the limit trying to keep up with payments, then lost the home and likely incurred a lot of other costs for establishing a new place to live and moving their belongings. Then they find out that as part of the process a chunk of the mortgage debt was cancelled and — surprise! — they owe a big tax bill.

There are a number of exceptions to the requirement to report COD income, including debt cancellation that occurs when the debtor is insolvent or in bankruptcy. Many homeowners will find that none of these exceptions apply, however. Congress is moving now to create a new exception.

Sticking points

The legislation has bipartisan support, but there is disagreement on two main points. The White House prefers a temporary relief measure, saying the existing exception for insolvency should be adequate under normal conditions. Democrats are pushing through a bill that creates a permanent new exception.

More importantly, the Democrats intend to follow their pay-as-you-go rules that generally require a budget cut or tax increase to offset any tax cut. Republicans say this relief should be provided without any offset, but in a close vote they lost a motion to that effect in the House of Representatives. Despite failing to remove the offset, most Republicans joined Democrats to approve the legislation, producing a lopsided 386-27 vote to approve. Senate action is pending.

Who's affected

The new exception applies only to taxpayers that meet certain requirements.

The discharge of indebtedness occurs on or after January 1, 2007. People that had debt cancelled in foreclosure earlier than that must rely on existing exceptions or, if they don't qualify, pay the tax.
The debt has to be incurred in the acquisition, construction or substantial improvement of the home. In other words, if you took out a home equity loan for a purpose other than home improvement, this relief isn't available.
The home has to be your principal residence. Relief isn't available if the loan was used to buy a property for rental or investment, or a second home.
Relief isn't available if debt was discharged in exchange for services you provided to the lender.

If you qualify for this relief, the amount excluded from income will reduce your basis in the home. This won't matter except in a situation where you ended up with an overall profit after the foreclosure sale. Even then, you may avoid tax because of a rule allowing people that meet certain requirements to exclude up to $250,000 of gain from the sale of a principal residence. But if you don't qualify for the $250,000 exclusion, or your gain exceeds the amount you can exclude, this basis adjustment can result in additional tax. The additional tax is likely to be smaller than if you had to report COD income, however.

And the Congress taketh away

[Update: The final version of the law did not include the tax change described below.]

Speaking of the $250,000 exclusion, Congress (or the Democrats, at least) decided to replace the lost tax revenue by tinkering with that rule. The rule allows you to exclude gain from your principal residence, not a secondary residence such as a vacation home. But many people have arranged to use the exclusion for two residences anyway.

Example: You own a main home and a vacation home. You use the $250,000 exclusion to avoid paying tax on gain from selling your main home and move into the vacation home. Two years later you use the $250,000 exclusion to avoid paying tax on the home that was originally your vacation home.

Under the new law, you'll lose part of the exclusion if you have a period of "nonqualified use" after the end of 2007. For example, if you use the home eight years as a vacation home (after 2007) and two years as a principal residence, 80% of your gain will be ineligible for the exclusion.

The pending law includes rules to protect people from paying tax on gain in some situations. For example, if you move out of a home and don't use it at all for a period of time until you can make a sale, this doesn't count as a period of nonqualifying use. There's also a rule to protect people that are not using a home because of military service.

Some people have expressed concern that this change in the law will depress real estate prices in areas where many people buy vacation homes. One of our message board regulars made this point, but then said, "On the other hand, maybe I should just shut up and buy a vacation home cheaply after the dust settles!"

Don't quote me on this

This description is for pending legislation that is still subject to change, so the details are not yet certain and it's even possible something will happen to prevent it from becoming law.