The end of the year is coming and with that, thoughts turn to taxes and filing, and for many perhaps the hope of a tax return to make up for Holiday splurges. However, if you have had a short sale or foreclosure in 2014, your tax situation may seem murky. The Homeowners’ Debt Relief Act of 2007 expired in 2012, then was extended until December 31, 2013. To date, it has not been renewed though Congress has considered bills to do so. This Act promised tax relief for debt forgiveness related to the loss of a primary residence. What does this mean for Arizona homeowners and why should you be concerned and why would there be taxes on a house you lost?
The first question many people ask is how could there be tax liability for a house I lost because I couldn’t afford it. How is there a gain to be taxed? The answers to these questions lie in the Internal Revenue Code section 108 which governs income from the forgiveness of debt and is based upon the IRS’ very broad definition of income. In this case, the rationale is that if you incurred a debt, say for a credit card, the consumer is able to use that debt to purchase some good or service thereby providing a benefit to them. Normally, debt is not income as it is repaid, but in the case of debt forgiveness the consumer has the benefit of the buying power of the debt, but then does not pay it back. The IRS views that the same way they do wages. This means that when you lose a house in foreclosure or even via a short sale, there may be “debt forgiveness” to the extent of any outstanding balance not paid by the sale of the house, known as a “deficiency”, and not thereafter paid by the borrower for whatever reason.
There are exceptions of course, and Congress made such an exception for debt forgiveness arising from the loss of a primary residence. Under the Act, a homeowner still had to declare the debt forgiven by the lender as income, but it was then not included as taxable income. Another exception is if the taxpayer is insolvent, this determination should be made solely by your tax professional. However, if the taxpayer is insolvent then the debt forgiveness is not taxable as income up to the amount of the insolvency.
Now that the Act has expired at the end of last year, how is the Arizona homeowner affected? The short answer is in most cases, not a bit. The key for debt forgiveness income to apply under IRC 108 is that there has to be a valid debt; that is one you legally owe as the consumer to the lender after the foreclosure or short sale. If there is no remaining debt, there can be no forgiveness of that debt and IRC 108 does not apply. In Arizona the vast majority of loans are non-deficiency loans, also known as non-recourse loans, if they were used “in whole or in part” to purchase the home or refinance the purchase of the home. The title of the loan doesn’t matter as much as what it was used for. For example, if equity was taken out to remodel a kitchen, or pay off other debt, then to the extent the money taken out is for those non-purchase uses, it becomes subject to a deficiency under Arizona law and there will likely be tax ramifications under a debt forgiveness analysis. If however the home equity loan was used to help finance the purchase of the home, there is no recourse and it is likely not to incur tax liability.
It is very important to obtain appropriate tax and legal analysis of your situation prior to tax filing. Make sure your tax professional is aware of the impact of the Arizona anti-deficiency laws on tax liability, most do, but it is a good question to ask. Even if you normally file on your own, this is probably a good year to obtain professional help. Improperly filing could cost you thousands in tax liability for phantom income or even penalties if you fail to properly report it. Also note that there are differences between tax law and Arizona law governing foreclosure and short sales. This is why it is very important to have both a legal and tax professional advise you if you have had one of these events occur in this tax year. A fuller discussion of the state of Arizona’s anti-deficiency protections and their interpretation via various court rulings are not addressed here.  Non-recourse means that the lenders sole recourse to recover on their loan is the property itself, there is no recourse against the personal assets of the borrower.  This is a quote from Arizona Revised Statute 33-729A, however the courts have limited the effect to the amount used to purchase the home where “in part” might otherwise apply which is why having a legal professional review your case is important.