Foreclosures, Deficiency, And Income Tax: Investment Loss May Offset Imputed Income For Some Investors

People facing foreclosures on investment property usually hope their lender will not pursue a deficiency judgment and will forgive balances due under their mortgage note. If the investor is fortunate enough to avoid a deficiency lawsuit he still faces income tax issues because of the general rule that forgiveness of a debt results in imputed taxable income. There is no imputed income if the real estate owner files bankruptcy or if he is insolvent at the time of the foreclosure. CPAs are dealing with foreclosure taxation issues for many of their clients during this tax season. I recently discussed with an experienced CPA the tax issues associated with foreclosure for those taxpayers not exempt from imputed income by reason of bankruptcy or insolvency.

The CPA explained that even those investors who receive 1099 forms because of  a lender’s release of deficiency liability may not end up paying additional income tax. He said that investors who use their investment property for a business purpose such as production of rental income can write off the losses associated with foreclosure in full in the year of their real estate loss. Generally, the owner's investment loss will offset  imputed income. On the other hand, investors who do not rent their investment property or use their property for another business purpose, but simply hold the property for appreciation, are not considered to use the property for a business. These passive investors can only deduct $3,000 per year of long term capital loss. The passive, non-business investor must amortize his investment loss over many years at the rate of $3,000 per year even though they must immediately recognize imputed income from a lender's debt forgiveness. Of course, as long as the lender retains the option of suing on the note for any deficiency there is not forgiveness of any debt and no imputed income.

The above summary is my understanding of the income tax effect of foreclosure and imputed income associated with the release of mortgage note liability. I am not a CPA and am not a tax attorney. Check with your own CPA if you have questions about your particular tax situation.

posted by Jonathan Alper, asset protection and bankruptcy attorney, Orlando, Florida