[IMGCAP(1)]The subprime mortgage crash of 2008 created a landslide of foreclosures and short sales which could persist for many years. A whole new industry in short sales has sprung up. All this has left taxpayers and their advisors scrambling for answers on the correct tax consequences.

It is vital that financial and tax advisors know the tax pitfalls in these transactions to best advise clients. In the worst case of adding insult to injury, property owners not only lose the real estate and all the money they have invested, but they also may have to pay income taxes.

This is due to the general tax rule that forgiveness of debt creates ordinary taxable income (Reg. 1.1001-2 (c), Rev Rul 90-16). This applies to short sales, foreclosures and Deeds in Lieu of Foreclosure.

Fortunately, there are some exceptions, but the rules are very strict. We have developed a procedure to determine the tax implications and advise our clients. I will outline the process, and then give some examples.

First, you need to decide if the mortgage was recourse (owner had personal liability) or nonrecourse (no personal liability). Basically, if they signed the mortgage they are personally liable. Generally, if a loan is nonrecourse, this is stated in the note itself. If the loan is nonrecourse, then there is no income from debt forgiveness.

With forgiveness on recourse or personally liable mortgages, the owner will receive a Form 1099A (Acquisition or Abandonment of Secured Property) from the lender or closing attorney showing the balance of principal outstanding (Box 2) and the fair market value of the property (Box 4).

The correct amount of debt forgiveness income is the amount of the mortgage debt in excess of the fair market value at date of foreclosure/short sale. You can use another value than that shown on Form 1099A if you have proof to the contrary. Selling expenses can be added to the debt to calculate total debt, but they are also deducted from the fair market value along with basis to determine the gain or loss. The full principal amount of any nonrecourse debt relieved is treated as the sales price.

Once you have calculated the correct amount of debt forgiven, then you have to determine how much is taxable.

The first exclusion deals with a primary residence where up to $2 million of forgiven debt is not taxed. This only applies to a mortgage secured by the principal residence of the taxpayer. The Mortgage Forgiveness Debt Relief Act of 2007 covers calendar years 2007-2012.

For second homes and other property, there is an exclusion for insolvency. You first have to calculate if the owner was insolvent immediately before the foreclosure or short sale. This means total liabilities exceed total assets. There is a worksheet Form 982 and instructions for this in IRS Publication 4681. If the owner is insolvent, then only the amount of insolvency is excluded from taxable income. Unfortunately, in most cases only a small portion of the forgiven debt qualifies.

If second homes or non-rental property are involved, the insolvency exclusion is the only help. But there is hope in the case of rental property. IRC Section 1231 basically states that the sale of rental property at a loss qualifies for ordinary loss treatment as opposed to capital loss. Of course, sale at a gain would be a capital gain. Thus, the loss on disposition of rental property could be offset against the forgiveness of debt income, adjusted for recapture of depreciation.

This is a developing area of the Tax Code, so we expect to see IRS rulings in the future.

Hank Klausman, CPA, RIA, is the president of the Klausman Group. He can be reached at (770) 640-6906 or hank@klausmangroup.com.