Cancellation of Debt on a Foreclosure

Should a borrower stop sending regular mortgage payments to his lender as agreed, he may face foreclosure of his home. A borrower's mortgage is secured by his property. By defaulting on the home loan and losing the property to foreclosure, he loses any and all rights to the home. Unfortunately, the foreclosure may not absolve the individual of his financial obligation to the mortgage.

Facts

Following a foreclosure, the bank will attempt to sell the foreclosed property. If it succeeds, it will apply the amount it receives for the home to the previous owner's loan balance (see Reference 1). Sometimes, the property sells for more than the original owner owed on her mortgage loan. Thus, the bank makes a profit and the original owner owes nothing. If the property does not sell for enough to cover the original home loan, however, the borrower owes the lender the difference between the amount recovered and the amount of her home loan. This is known as a mortgage deficiency.

Significance

When faced with a mortgage deficiency, a bank has two options. It may pursue the borrower for the deficiency in court via a lawsuit or write off the deficiency as a tax loss. Writing off the deficiency is known as "cancellation of debt." Once a lender cancels the debt, it can send the borrower a 1099 form detailing the amount forgiven and claim that amount as a business tax deduction. The borrower, however, must claim the forgiven deficiency as income on the following year's tax return (see Reference 2). Depending on the amount of the deficiency, this could leave the borrower facing a significant tax debt due to the foreclosure.

Considerations

According to the IRS, the Mortgage Forgiveness Debt Relief Act (MFDRA) protects consumers from paying taxes on foreclosure write-offs. The MFDRA went into effect in 2007 and will remain in effect until December 31, 2012. Not all individuals are eligible for tax protection under the MFDRA. Individuals whose foreclosure debts one million dollars (two million for married couples) or those who lost any residence other than their primary residence to foreclosure are still responsible for paying taxes on the forgiven debt. To take advantage of tax protection under the MFDRA, a debtor must file Form 982 and submit it to the IRS along with his tax return (see Reference 3).

Benefits

If a borrower's original mortgage loan was categorized as a "non-recourse" loan, the lender may foreclose on the property and forgive any remaining balance, but it can neither send the debtor a 1099 nor can the IRS expect the individual to pay taxes on the amount forgiven. Non-recourse loans restrict lenders by forcing them to accept the property as full repayment of the loan balance (see Reference 4). Thus, non-recourse lenders are also prohibited from pursuing a mortgage deficiency after a foreclosure.

Prevention/Solution

A mortgage deficiency is an unsecured debt. Although the original mortgage debt was secured by the property, the lender already claimed the property as collateral. Depending on a consumer's current assets and income, he may be eligible to discharge his obligation to pay the mortgage deficiency via a Chapter 7 bankruptcy. Debts discharged through bankruptcy proceedings are not taxable (see Reference 4).