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Let's Give the IRS a Break

posted by Bob Lawless

Geraldine Fabrikant has a story in today's New York Times tells a story about how U.S. homeowners can get hit for a big tax bill after a foreclosure. That is correct. If someone lends you $200,000 and then later forgives the debt, you've made money. The income tax laws treat the forgiven debt as taxable income. The reason should be clear. If we did not tax forgiven debt as income, consider the huge loophole that otherwise would exist. Parties could transfer all sorts of wealth by pretending it was "forgiven debt." Our taxing authorities would spend all sorts of enforcement resources policing such abuse.

The rules on forgiven debt are known as the "Cancellation of Debt Income" or "COD" rules, and they apply to the largest corporation and to the modest homeowner. Thus, when a bank takes a home in foreclosure and forgives the remainder of the mortgage debt, the difference between what was paid (i.e., the home's value) and what was owed is taxable income to the homeowner. The New York Times story relates how several homeowners ended up with tax bills for tens of thousands of dollars.

My only concern with the New York Times is that it might leave the impression that these rules are something the U.S. Internal Revenue Service recently thought up to make life more difficult. The truth is that the COD rules date back to a 1931 decision of the U.S. Supreme Court. With the rise in mortgage foreclosure and the decline in housing values, we are just seeing a lot of situations where homeowners might have COD income. The entire matter is now governed by statute, including the rule that no COD income arises when the debt is canceled when the taxpayer is insolvent (or in bankruptcy court). Check out sections 61(a)(12) and 108 of the Internal Revenue Code. As much as I am loathe to rise to the IRS's defense, I think we have to give them a pass here. They are just doing their job, which is enforcing the tax laws Congress has given them. Complaints should be addressed to Capitol Hill.

A few thoughts:

(1) There are numerous exceptions to the COD rules. For example, "qualified farm property" is an exception. Also, debt canceled in a bankruptcy case is not counted as income. Congress can fix this, if it wants, simply by making excluding from income debt canceled in a bona fide foreclosure or workout on the debtor's primary residence.

(2) The New York Times story relates the tale of one taxpayer where Wells Fargo had taken back the residence on a credit bid of $1 because no one else appeared at the foreclosure sale. Wells Fargo then reported the entire difference between the mortgage debt and $1 as COD income to the IRS. Eventually, the taxpayer prevailed, convincing the IRS that the value of the residence was at least as much as the amount of the mortgage debt and hence the taxpayer had given up as much as the taxpayer had gained. Where's the IRS on these 1099s? Sure, the taxpayer won in the end but was out the professional fees and time it took to prevail with the IRS. Valuing the house at $1 was sure to cause the taxpayer problems with the IRS. The IRS has enforcement authority over the accuracy of the matters reported to it, and it should make sure financial institutions report the difference between the outstanding debt and the full appraised value of the residence.

(3) The COD rules do not apply when debt is canceled while the debtor is insolvent. One might think that anyone who gives up their home in foreclosure is insolvent, but that may not necessarily be the case. If the mortgage foreclosure makes the debtor solvent, then the COD rules apply to the extent the canceled debt made the debtor solvent. Normally, the burden of proof to show insolvency would be on the taxpayer, as it is for most everything in tax law. The IRS could ease the burden of proof rules here and make it easier for homeowners to show insolvency at foreclosure and avoid COD income.

Comments

The main problem here, as I see it, is that, as with all tax obligations, the entire balance of the tax is due immediately. This is an immediate problem for someone who has worked out a short sale on their home (or, more annoyingly, had their property foreclosed upon), since the tax obligation itself cannot be used to render the person insolvent once again.

Our Internal Revenue Service generally has the discretion in how it handles tax collections. Instead of making the taxpayer ask, why not be proactive and advise the taxpayer that a payment plan is available? Perhaps even put one together based on the payer's wages and dependents (if only there existed a form that someone could fill out to advise the IRS of all of this information) and send it off. "If you want this, sign here; otherwise, sign a check." Having a "we realize you owe unexpectedly, and we have programs to help" attitude would go over a lot better than "pay up or we take what little else you have."

If anyone needs a public image makeover, it's the IRS.

No, the problem here is that the "debt" that was cancelled was a fictitous transaction, debt created on the banks books (see Fractional Reserve Lending on Google), and the I.R.S. thinking its entitled to tax on a debt that is forgiven, even when that 'debt' has no real value to begin with.

Methinks that the fantasy of homeownership is revealing itself to be another domino in the false economy of debt-based "growth", and it will not, cannot last.

The biggest problem with the statute (IRC §108) is that tax is assessed and collected from many people who do not actually owe taxes under the statute.

Very few consumers know about the statute, much less understand it. Creditors can use the statute to gross up the loss writen off to an amount greater than the facts warrant (albeit not legally). I am representing a bankruptcy client for whom the mortgage creditor reported it lost $300,000.00 by Form 1099 on a $78,000 loan. So how did the lender lose $300,000.00 on a Texas foreclosure of a $75,000.00 house? Texas foreclosures are quick and simple compared to those of many other states. By the time the client showed up in my office the statute of limitations had long since passed for a fraud claim against the lender.

If the debt written off does not make the debtor solvent then no income exists to legally recognize and tax. Far too often the creditor sends in the required Form 1099 correctly, the IRS shows up three years later with massive penalties and interest tacked onto the alleged tax due. The client shocked, scared and clueless knuckles under to the IRS demands.

Section 108 is an excellent IRC section to eliminate in regard to consumer debt.

Regards,

Charles Kennedy,
Attorney and CPA

I don't know if this is the correct forum for this but I'm looking for some advice. I just received a tax bill for $30,000 from the IRS. In 2005, my ex-wife and I had filed a Chapter 7 and the mortgage holder requested the home be removed since I owed more on it than it was worth. Now 2 years later, I receive this tax bill. What steps can I take?

Great blog and I really enjoyed reading it. I appreciate your effort and the quality of the information you provide.

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