Many homeowners under threat of foreclosure attempt a short sale or a deed-in-lieu-of-foreclosure settlement. Their goal is to escape liability for a potential deficiency between the selling price of the distressed property and the amount owed on the original loan. For federal income tax purposes, such a cancellation of debt (COD) is generally considered ordinary income. Many distressed homeowners face the risk of not only losing their homes but also owing thousands of dollars in income taxes. This article describes contexts in which COD tax liability arises, explains how such liability can be avoided, and analyzes policy implications of such liability.
When does COD taxation arise? When homeowners seek to keep their homes with modified loan terms, such modifications traditionally have been treated as COD income if the modifications are deemed significant. Alternatively, homeowners unwilling or unable to modify their loans may seek short sales or deeds in lieu of foreclosure, which also have generated COD taxation discussions. In such scenarios, homeowners bargain for a settlement in which a lender accepts less than the full amount owed in return for a sale to a third party or for the relinquishment of the deed. In return for generating such a sale or for recovering the property, lenders often waive their right to collect the deficiency. The forgiveness of the deficiency owed is a classic example of COD income and normally would generate tax liability at ordinary income rates.
Unfortunately, homeowners using waivers of deficiencies face a Hobson’s choice: They can declare bankruptcy, costing a few thousand dollars in attorney’s fees and discharge personal liability; or they can settle with their lender and face many more thousands of dollars of tax liability from COD income taxed at ordinary income rates.