Debt Forgiveness on Strategic Defaults

There are lots of questions floating around about the process and consequences of pursuing a strategic default strategy.  One particular question gets asked a lot: What are the tax consequences of debt forgiveness and, more specifically, of a strategic default.  The general rule is that forgiven debt is taxable.  For example, assume that Borrower takes out a loan for $100,000.  Assume also that Borrower pays down the loan principal balance to $50,000 and then defaults.  If borrower and lender work out an agreement allowing Borrower to walk away from the loan for $30,000 (i.e. if the bank forgives $20,000 of the outstanding balance), then a taxable event has occurred.

The general rule is that if you borrowed money from a commercial lender and the lender later cancels or forgives the loan (or any portion of the loan), you may have to include the forgiven amount in income on your tax returns.  Without special provisions in the Internal Revenue Code, this general rule would apply to strategic defaults.

Special Tax Rules for Strategic Default

The Mortgage Debt Relief Act of 2007 makes a special provision for debts forgiven in conjunction with mortgage foreclosures, strategic defaults, or loan restructurings.  Specifically, the law excludes up to $2,000,000 of forgiven or restructured debt on a primary residence from being taxed as canceled or forgiven debt.

The importance of the Mortgage Debt Relief Act cannot be overstated.  The law has the effect of alleviating an already precarious real estate market and economy, which would be adversely impacted by taxation of forgiven mortgage debt that defaulted simply because homeowners couldn’t come up with the cash to pay their loans.  A tax bill on top of a foreclosure would just ad insult to injury.

State Laws and Strategic Default

States differ drastically in terms of whether they allow for deficiency judgments and whether or not they tax forgiven loans or mortgages.  For example, California provides an exemption from including mortgage forgiveness in California gross income for discharges occurring in the years 2009 through the end of 2012.  While the California law is not as generous as the federal provision, it does exempt up to $500,000 of discharged mortgage debt from taxation under California’s personal income tax through the end of 2012 (though the amount of total debt used to calculate the exclusion is limited to $800,000).

Foreclosure After Strategic Default Counts As Forgiveness

If a lender forecloses on property and sells the property for less than the amount of the underlying loan, federal and California state laws consider the deficiency to be forgiven.  Some states do allow for a deficiency judgment to be maintained against the borrower, which means that a lender could, in theory, sue a borrower for the difference between the loan amount and the amount received at a foreclosure sale.  In practice, however, fear of a deficiency judgment is simply not a good reason to fear a strategic default.  The existence of laws exempting forgiven debt from taxation is evidence of the fact that even in states where deficiency judgments are permitted, it rarely happens in practice.

While the concept of strategic default is very straightforward, most people are rightfully concerned about the consequences.  You’re not alone and you don’t have to worry about being in the dark.  Simply pick up the phone and call an asset protection attorney today.  We’ll be more than happy to help you understand and navigate the process of a strategic default.