Foreclosure and Tax Debt Cancellation Release from Bills.com
Housser explains CODI tax, homeowner options
SAN MATEO, Calif., Nov. 14, 2007 - This year will go down as one of the worst for homeowners living on the edge, but Bills.com co-founder and co-CEO Andrew Housser cautions homeowners facing foreclosure not to add to their worries with the unpleasant surprise of tax owed on a foreclosed home. "Buyers who are 'upside down' (meaning the house is worth less than their mortgage) are often at greatest risk of foreclosure, when the lender reclaims the home and sells it to recoup its loss," Housser said. "Even after foreclosure, though, beware: the previous owner's commitment is not finished. In some cases, a big tax bill can hit - and hit hard." In the first half of 2007, 55 percent more foreclosures were recorded than the same period the previous year -- putting the United States on track for about 1.3 million foreclosures during 2007. Some of those homeowners can face serious tax problems if they do not understand the consequences of foreclosure, Housser warned. Here are the steps of the foreclosure and tax process -- and what foreclosed homeowners can do:
- Foreclosure: After foreclosure, the lender will subtract sale proceeds from the mortgage balance and then add the fees associated with the foreclosure and sale.
- Balance calculation: Whatever amount remains due is called the "deficiency balance." In some states, lenders are allowed to collect on mortgage deficiency balances; in others, they are not.
- Understanding CODI: In any state, if the lender agrees to waive part or all of the deficiency balance (either because they are bound by law to do so, or as a result of negotiations), the forgiven debt will be treated as income. This forgiven debt is called "cancellation of debt income" (CODI), discharge of indebtedness income or discharge of debt. If the lender agrees to waive all of the deficiency balance, the amount of income is the difference between what the bank sold the house for and what the consumer owed. For example, if the consumer owes $100,000 on the house when it goes into foreclosure, and the bank sells the home for $60,000 (and forgives the rest), the CODI on which tax would be assessed would be the difference of $40,000. In other words, the bank takes a $40,000 tax-deductible loss; per IRS standards, someone - the homeowner, in this case - must take the amount as income.
- Tax liabilities: A consumer whose house has been foreclosed on may receive an IRS Form 1099 for, and be required to pay tax on, the CODI amount. CODI is taxed at standard rates, from 10 percent to 35 percent, depending on the individual’s income tax bracket. "The situation can create a major financial problem, as the homeowner winds up paying tax on money that he or she never sees," Housser noted. In the example above, $40,000 CODI could result in $4,000 to $14,000 in federal taxes (or more when state taxes are included). Sometimes, because the homeowner is moving, the tax form gets delayed in the mail. "If you anticipate a 1099 form for CODI and do not receive one, contact the IRS or your former lender to locate the form," Housser warned. "Don't assume you are not liable for taxes if you do not receive the form. If you are late paying the taxes, penalties and interest will accrue, making the debt that much larger."
- Options: Most people who could not pay the mortgage and end up with a foreclosure also are unlikely to be able to pay tax on CODI. There are legal ways to avoid paying taxes on this income. Individuals who are truly insolvent (total liabilities are greater than total assets) at the time of the CODI can file IRS Form 982 declaring the insolvency and have CODI waived. To learn whether you qualify for either of these, consult a licensed tax advisor.
"No matter what route you take, resolving your home situation is very important," Housser added. "If you think you may face a CODI tax liability, start talking to a tax professional now. Be sure to wrap up all the loose ends so you can be truly free -- and move forward to healthier financial circumstances." Based in San Mateo, Calif., Bills.com is a free one-stop online portal where consumers can educate themselves about complex personal finance issues and comparison shop for products and services including credit cards, debt relief assistance, insurance, mortgages and other loans. The company blogs about consumer finance issues at http://www.bills.com/. Since 2002, Bills.com has served more than 30,000 customers nationwide while managing more than $500 million in consumer debt. Bills.com is a division of Freedom Financial Network, LLC, whose co-founders and CEOs, Andrew Housser and Brad Stroh, have been named Northern California finalists in Ernst and Young's Entrepreneur of the Year Awards.