Debt cancellation happens when you are relieved of the responsibility to repay the debt.
But the IRS considers the amount of the debt forgiven to be taxable income to you.
In some cases, it can be quite severe if you don’t manage the situation and make the right decisions.
For instance, you can’t make payments on your Real Estate Note, and it goes into Default.
So the Lender says, “Instead of me having to go through the process of Foreclosure, why don’t you just sign a Deed In Lieu of Foreclosure over to me on the property, since you are going to lose the property anyway?”
And you don’t see any downside to this process, and you also don’t see any other options, so you agree to do it.
There are some possible serious downsides to this.
And you need to know what they are.
So, I will tell you.
DEBT CANCELLATION BY DEED IN LIEU
When a Borrower has defaulted on the loan that is secured by his real property, either his residence or his investment real estate, the Lender has a legal right to foreclose on the property, and take it back.
The Lender will no longer expect to receive monthly payments on the Mortgage, or Real Estate Lien Note, and this results in debt cancellation.
But if the Borrower accepts the situation, thinking there is nothing he can do to prevent it, he is likely to deed the property directly to the Lender, using a deed called a Deed In Lieu Of Foreclosure.
This process saves the Borrower from having a Foreclosure showing up on his Credit Report, as well as avoiding additional costs for the Lender, for which the Borrower will ultimately be responsible.
But signing a Deed In Lieu can cause bigger problems than these for the Borrower.
It can even create a liability for taxable income, and in some cases, liability for two different taxable incomes.
DEBT CANCELLATION IS TAXABLE INCOME
First, understand that the IRS looks at a transaction of you deeding property back to the Lender as the same as you selling the property to the Lender.
The Sales Price is declared to be what the Fair Market Value (FMV) of the property is at the time of the filing of the deed.
If the Fair Market Value of the property is $260,000 and the Borrower owed more than that to the Lender, say the Remaining Principal Balance was $300,000, then the difference is considered a type of income for the Borrower known as Cancellation Of Debt (COD) Income.
And this $40,000 of income would be considered Ordinary Income, which means that it would be taxed at the Borrower’s Marginal Tax Rate.
This is one type of possible income.
But there is also another type of income.
DEBT CANCELLATION AND CAPITAL GAINS
The other type of income is one that you would never think about.
If the Borrower has owned the property for quite a few years, and has just been refinancing it periodically during that time, he might even have a low Basis in the property, due to all of the Depreciation claimed, which lowers the Basis.
If the Borrower’s Basis in the property is $200,000 at the time that he signs the Deed In Lieu, remembering that the IRS considers this process to be a Sale of real estate by the Borrower, he would have a Capital Gains of $60,000 to report on the $260,000 “sale.”
And, as I said, the bad part is that most of this $60,000 probably represents the Depreciation that the Borrower has taken over the years, so the type of tax due will be the one called Depreciation Recapture Tax.
Depreciation Recapture Tax is levied at the Borrower’s Marginal Tax Rate, up to a maximum of 25%.
So, be aware, before you sign that Deed In Lieu, that it might not be the great deal that you thought it was.
But, let’s go further.
What to do?
DEBT CANCELLATION ALTERNATIVES
Well, of course, it depends on your personal circumstances, but you might consider just not signing the deed, but trying to work with the Lender to find a better solution, that will also work for him.
Tell the Lender to go ahead and foreclose.
The property is worth $260,000.
You owe $300,000.
At the Foreclosure Sale, no one will bid the full amount of the Fair Market Value of $260,000 because these are people looking for a bargain.
And besides, the Lender can outbid everyone because they don’t have to come up with the money, they can just credit what they bid against what you owe.
So, the Lender will probably buy the property, for around $220,000.
After the Foreclosure Sale, the Lender is entitled to file a lawsuit against you for the difference between the Net Sales Proceeds and the Remaining Principal Balance on the note, which would be $80,000.
They would win, of course, and obtain a Judgment against you, called a Deficiency Judgment.
They might go for the Judgment against you, or they might just report the Deficiency amount on your Credit Report.
But you want to put this in your past, so you tell the Lender that you will agree to have them get the Judgment, and then you are willing to settle the Judgment for a payment from you of $10,000.
Tell them that is all the money you can come up with, and if they sue and get the Judgment, you will have to file Bankruptcy, which will wipe out the Judgment, and they will get nothing.
Don’t worry, it won’t make them mad at you. This happens to Lenders often, they understand it is just business. They would do the same to you.
So, they will probably agree and do it.
This way, you will not be charged with the Capital Gains Tax liability, you will probably save a lot of money, and you will not have to deal with the IRS for the next two or three years.
A Deed In Lieu Of Foreclosure can be more of a problem than a solution.
I touch on this same concept in more than one of my books, but the one with the most detailed information is “Do This, Not That!” If you would like to preview it, you can go here on this website to look at it first, use the 3D Flip Reader to look at the Contents and read the first few chapters.
The paperback is available on my Amazon Author Page, along with my other books.
And I have related Articles about real estate investing and other real estate matters from other perspectives on my LinkedIn Page.
I am also active on Quora.com where I have answered over 300 questions, and they have almost 3 Million views.
If you happen to be doing, or if you are considering doing, a Section 1031 Like Kind Exchange, then you should start with a Dictionary, and I have done one, in 3 separate Blog Posts here: Part 1, Part 2, and Part 3. And I have a lot of material for you to consider on my S1031 Exchange website.
You should always check out the credentials of anyone, like myself, who you are relying on for accurate information by looking closely at their Biography. Here’s mine.
And if you think you might like to read one of my books, but can’t decide which one, here are four that I recommend.
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