Interesting discharge of indebtedness income issue in a front-page New York Times story:  After Foreclosure, a Big Tax Bill From the IRS, by Geraldine Fabrikant:

Two years ago, William Stout lost his home in Allentown, Pa., to foreclosure when he could no longer make the payments on his $106,000 mortgage. Wells Fargo offered the two-bedroom house for sale on the courthouse steps. No bidders came forward. So Wells Fargo bought it for $1, county records show. …

on July 9, they received a bill from the Internal Revenue Service for $34,603 in back taxes. The letter explained that the debt canceled by Wells Fargo upon foreclosure was subject to income taxes, as well as penalties and late fees. …

Notices of unpaid taxes, unanticipated and little understood, will probably multiply as more people fall behind on their mortgages, said Ellen Harnick, senior policy counsel at the Center for Responsible Lending, a nonpartisan research and policy center in Durham, N.C. Foreclosure is one way that beleaguered homeowners can fall into this tax trap. The other is when homeowners are forced to sell their homes for less than the value of the mortgage. If the lender forgives that difference, they are liable for income taxes on that amount. The 1099 shortfall, as it is called, stems from an IRS policy that treats forgiven debt of all types as income even if the taxpayer has nothing tangible to show for it, unless the debt is canceled through bankruptcy. …

“The tax laws are far too complex for borrowers to understand,” said Kurt Eggert, a professor at Chapman University School of Law, noting that there are distinctions between selling a house for less than the loan amount and losing one in foreclosure. He says it is crucial to get expert tax advice to sort through the bewildering complications. The whole concept can be counterintuitive. “Your home has declined in value and you lose it,” Mr. Eggert said. “Then the IRS says you owe tens of thousands in taxes because you got a windfall when the debt was forgiven.”

For commentary by these Tax Profs, see below the fold:

• Bryan Camp (Texas Tech)
• Sheldon Cohen (Farr, Miller & Washington; former IRS Commissioner)
• Linda Galler (Hofstra)
• Stuart Lazar (Tulane)
• Jim Maule (Villanova)
• Marty McMahon (Florida)
• David Shakow (Penn)

Bryan Camp (Texas Tech):

The article does a pretty good job at identifying both the root cause of the tax troubles that foreclosures cause and how taxpayers can best deal with those troubles. I have a few observations on both the causes and the remedies.

The cause of these tax mis-adventures reported in the NYT is the bulk-processing system that the IRS must use to administer the tax laws. In this case, the problem stems from how the third party reporting system created by Congress is used. Debt forgiveness is income. The article is mistaken when it claims that this is a mere matter of "Internal Revenue Service policy." It’s the law. That’s the decision Congress made, codified in section 61, and the IRS must follow the law.

It is likewise a Congressional decision that, when a bank or other creditor forecloses on a debt, they must report the amount of debt forgiven to the IRS. That duty is written into the law, in section 6050J. Likewise, when a title company, lawyer, or other agent brokers a real estate deal, they must per section 6045(e) report the gross amount of the sales proceeds distributed to the seller. It is the IRS, however, that creates the forms to use (Form 1099 in both cases I think) and figures out how to process the forms.

The bulk processing problem comes into play in how the IRS chooses to use the information reported on Forms 1099. Just because income is reported on a Form 1099 does not mean that the amount is really taxable income. Third party reporting is overinclusive. But what it DOES mean is that the taxpayer is now behind the 8 ball. Because the IRS uses its computers to match the income which third parties report on Forms 1099 with the income taxpayers report on their Form 1040s. When there is a significant enough mis-match, the IRS processing instructions assume that the taxpayer has failed to report income and so sends out a letter that says, in essence: "Dear taxpayer, our records show that you failed to report $x income and we proposed to adjust your tax return to include that income. Doing so will increase your tax bill by $y. If you have any good reason why we should not do this, then let us know."

The letters sent to taxpayers by the IRS are usually pretty hard to read. Especially when your hand is shaking… But they generally give the taxpayer 30 days to write in an explanation of why the income reported by the creditor or the real estate broker is NOT reportable income. After that, the IRS sends the taxpayer a formal "Notice of Deficiency" which generally allows the taxpayer 90 days to contest the matter in Tax Court.

The letters are produced in the IRS bulk-processing centers, called "campuses" that are staffed by hard-working, but poorly paid (because Congress does not see fit to provide sufficient resources) low-level employees. The idea is that these employees are not to be trusted with too much discretion because they have neither the training nor the aptitude to make anything but simple decisions. They are rule-bound minions, acolytes to the great computer system that is the true administrator. Memo to Congress: You get what you pay for. You want better taxpayer service? You gotta fork over the money to be a competative employer.

This is likely what happened to Mr. Stout, whose story frames the NYT article. Since the bank "bought" the house for $1, it probably sent in a Form 1099 reporting that it had fogiven the rest of his $106,000 debt. That, of course, it utter nonsense. The better view of what happened is that Mr. Stout transferred his house to the bank in satisfaction of the debt. The true question is how much that house was worth. It is absurd to think it was worth only $1. The better evidence of its fair market value is the actual sales price it fetched when the bank resold it, or $106,000. That wipes out his debt with nothing left over. The second best evidence of value is the re-sale of the house for $140,000. In that case, Mr. Stout gave the bank an asset worth $140,000 to pay off his $106,000 loan. Either way, however, the only economic benefit that Mr. Stout got out of the deal was paying off the $106,000 debt. There was no income for him to report from these transactions, at least based on the facts reported in the article.

So what remedies does a taxpayer have when a third party has sent in an incorrect Form 1099? The article does a good job in identifying the two most common remedies. First, you can get the third party to correct the Form 1099. Mr. Stout’s close encounter of a taxing kind illustrates that remedy. Notice, however, it took contact from the NYT reporter before the bank said "oops." Again, that is because it is typically low-level bank employees who fill out and send in the Form 1099. They are private sector minions who are acolytes to their own processing rules. But if you can get the third party to change the Form 1099, that’s generally the easiest way to fix the problem.

The second remedy is to explain to the IRS why the Form 1099 is incorrect or explain why the amount reported on the Form 1099 is not income. I had to do that one year when I administered my grandmother’s estate. She had left her home to myself and my two siblings. We sold the house (it net all of $32,000 !) and split the proceeds three ways. Even though this represented a bequest from my grandmother (thus excluded from income under section 102) and even though I split the money with my siblings (and so did not receive all $32,000), the title company sent in a Form 1099 reporting income to me of $32,000. I recieved a missive from the massive IRS and had to write back to explain why I did not need to include that amount in income. I was truly mad at that title company and will never, ever, use their services again. But like other third parties, the title company has every reason to report the income and no reason not to. They are subject to penalties for failing to report and are not subject to any penalties for false reporting (unless you can prove they did it with some specific intent to hurt you).

The article does a good job—through the quotes from Ms. Thompson—in identifying one typical explanation: the taxpayer’s insolvency. Congress does not require taxpayers who are insolvent at the time of the debt forgiveness to report debt forgiveness as income. That’s in section 108. Insolvency just means that even after the debt forgiveness, the taxpayer still has more debts than assets to pay them.

The difficulty with both these rememdies is the same that you face in any interaction with a large bureaucracy, whether public or private: getting through to someone who can help you. While most IRS employees are professional and polite, they have limits in what they can do for you, especially those who work in the campuses who are very restricted in their discretion. Fortunately, if they cannot help you and the problem persists and threatens to cause you significant hardship, you can turn to the Taxpayer Advocate Service, which is charged with helping taxpayers caught up in red tape get through to the person who can help. Again, however, although these folks are generally wonderfully hard workers who try their best, they are also faced with resource constraints imposed on them by a parsimonious Congress, a Congress which has consistently proved itself to be penny-wise and pound-foolish when it comes to funding the Internal Revenue Service.

Sheldon Cohen (Farr, Miller & Washington; former IRS Commissioner):

The bank filed an erroneous 1099 and the IRS billed on it.  That is all that happened.  No one investigated and it was corrected when they got the correct info.  Case closed.

Linda Galler (Hofstra):

This morning, I asked my colleagues on the TaxProf list serve about an article that appeared on the front page of the New York Times several days ago, regarding the tax consequences of mortgage foreclosure. That article highlighted the plights of several individuals whose houses were foreclosed upon due to their inability to make mortgage payments, and who then received correspondence from the IRS asserting a realization of income from discharge of indebtedness. In one case, a house appraised at about $133,000 was purchased at auction by the lender for $1, there being no other bidders. The IRS letter explained that the debt canceled on foreclosure was income. The purposes of the Times article apparently were to highlight the “tax trap” to homeowners already in precarious financial situations and to elicit sympathy for those losing their homes.

The consensus of the group was that the IRS (at least as reported) was wrong. There cannot be discharge of indebtedness income unless the amount of forgiven debt exceeds the value of property transferred in satisfaction. For the IRS to have been right, the value of the property must really have been $1 – a ludicrous assumption. The fact that the lender resold the property for $106,000 to a purchaser who resold it one month later for $140,000 (in a condition not elaborated upon in the article), and the existence of a pre-foreclosure appraisal of $133,000 suggest that the value of the house was at least equal to the amount of the loan forgiven — $106,000. Therefore, there could be no discharge of indebtedness income. (The homeowner’s tax liability, other than discharge of indebtedness, would depend on his adjusted basis in the home.)

The IRS must have learned about the foreclosures from the lenders, who are required to report on Form 1099-A any acquisition of property that was security for a loan. The form, however, does not indicate what the homeowner’s basis was, that information not belonging to the lender. But the lender does get to report its assessment of the property’s value and the amount of debt outstanding, indicating how much debt is forgiven. The situation described in the Times article was resolved by the lender correcting the 1099-A to show that the fair market value of the home was actually more than the amount owed by homeowner. The IRS can hardly be blamed for relying on 1099-A forms so long as taxpayers are given a fair chance to prove that the lender was wrong or that basis reduces, or even erases, income or gain. Letters from the IRS – indeed “bills” for “back taxes,” in the jargon of the Times article – are scary and intimidating, but a reasonable tax administrator should be able to quickly and easily resolve issues like this one, rescuing taxpayers from the “tax trap” so chillingly described by the New York Times.

Stuart Lazar (Tulane):

The taxpayer CLEARLY has DOI to the extent that the FMV of the house is less than the $106K loan balance. And there would be no deductible loss for the taxpayer as a result of Section 165(c). That said, was the FMV of the house really $1? The sale by the bank to an "unrelated" party for $106K shows that it was not. It is unclear why the bank would bid $1 instead of the loan balance of $106K as any loss on the original loan would be offset by the subsequent sale. Bank should have bid $106K which would have helped the taxpayer’s position.

So where is the fraud? Is it that the house later sold for $140K? Based on the facts, there is not enough information to know whether the increase in price from $106K to $140K was inherent at the time of the "auction", whether the purchaser made any improvement, or whether the market or marketing of the property resulted in a higher later sale.

End result: Taxpayer should not have had any DOI since the bank got a house worth $106K in exchange for its loan "bad" loan.

Jim Maule (Villanova):

The facts also suggest that the bank was acting as the taxpayer’s agent in disposing of the property. If, as it turned out, there was someone willing to pay $140,000 for the property, then why would the taxpayers have sold the property for one dollar? Surely the house did not increase in value 140,000-fold in a few weeks. Sense can be made of what happened if the one dollar transfer is seen as a formality to give the bank legal title so that it could sell the house on the taxpayers’ behalf. Under this analysis there is excludible gain from the sale of a principal residence rather than includible discharge of indebtedness income. Additional facts, if they exist, could corroborate this analysis. It would be helpful to know what communications passed between the taxpayers and the bank.

Though it has been suggested that the taxpayers would be left not only with gross income from the discharge of indebtedness but also a capital loss unlikely to be of use, the outcome would be worse. Because the property was the taxpayer’s personal residence and not business or investment property, there would not be a deductible loss. So even if the taxpayers had capital gains that could be offset by a capital loss, this transaction would not provide that offset.

Marty McMahon (Florida):

Where a taxpayer transfers property in satisfaction of a claim, the transfer is viewed as two separate transactions: (1) a sale of the property by the debtor for cash; and (2) the payment of that cash by the debtor in discharge of the obligation. Although the second transaction is not a sale or exchange, the property transfer is considered to be a sale or exchange. Kenan v. Commissioner, 114 F.2d 217 (2d Cir.1940), held that the transfer of appreciated securities by testamentary trustees in satisfaction of a $5,000,000 bequest qualified as the sale or exchange of capital assets. Similar results were reached in Rev.Rul. 66-207, 1966-2 C.B. 243, and Rev.Rul. 67-74, 1967-1 C.B. 194. The same principle has been applied in transactions involving mortgaged property. Helvering v. Hammel, 311 U.S. 504 (1941), held that a loss sustained by an owner of real estate resulting from a foreclosure was a capital loss; the involuntary nature of the transaction did not make it any less a "sale." This rule was extended to nonrecourse liabilities in Helvering v. Nebraska Bridge Supply & Lumber Co., 312 U.S. 666 (1941). The voluntary conveyance or abandonment to a mortgagee of a capital asset also has been held to qualify as a sale or exchange. Yarbro v. Commissioner, 737 F.2d 479 (5th Cir.1984), and Middleton v. Commissioner, 77 T.C. 310 (1981), aff’d per curiam, 693 F.2d 124 (11th Cir.1982). The Yarbro court found abandonment followed by foreclosure as no different in substance than quit-claiming the mortgaged property to the mortgagee, which had been held in Freeland v. Commissioner, 74 T.C. 970 (1980), to be a sale.

The principles are all captured in Reg. § 1.100-2, Example (8). In 1980, F transfers to a creditor an asset with a fair market value of $6,000 and the creditor discharges $7,500 of indebtedness for which F is personally liable. The amount realized on the disposition of the asset is its fair market value ($6,000). In addition, F has income from the discharge of indebtedness of $1,500 ($7,500 – $6,000).

Thus, as others have said, the value of the property is crucial in computing the COD income. Only the excess of the debt over the FMV of the property can be COD income. And it can’t be COD income unless and until the debt is discharged by the lender under state law. As long as the lender has the right to sue for any deficiency, there is no COD income, because that aspect of the transaction is not closed.

McDaniel, McMahon, Simmons & Abreu, Federal Income Taxation: Cases and Materials 1188-1189 (Foundation Press, 5th ed. 2004).

David Shakow (Penn):

Section 1.1001-2(a)(2) says that the amount realized on a sale or other disposition of property that secures a recourse liability does not include amounts that are (or would be if realized and recognized) income from the discharge of indebtedness under section 61(a)(12). I believe the amount that constitutes income from the discharge of indebtedness is a matter of fact. If there is a $106K mortgage, and the bank takes the house, discharges the mortgage, and sells it for $106K, I would feel comfortable representing a taxpayer who wanted to argue that no debt had been forgiven. I would not be so happy if I had to argue that there was debt forgiveness income. I would feel foolish if I had to argue, under these facts, that it would make a difference if the bank had bought the house in at the auction for $106K.