Financial Lending Notes
May 5, 2010

Debt Forgiveness and Foreclosure: Tax Consequences

Do you realize that forgiveness of debt as part of a loan workout plan may be a taxable event for borrowers? If not, your borrowers could be in for a very unwelcome surprise from the IRS.

For example, suppose you accept $300,000 from a borrower as satisfaction of a $500,000 debt. The IRS takes the position that the $200,000 difference is ordinary taxable income to the borrower, and you are required to send the borrower a Form 1099 stating this.

In addition to a legal obligation to send the 1099 form, lenders face an ethical obligation to inform borrowers that there may be potential tax consequences of debt forgiveness and that they should consult a tax advisor. Otherwise, borrowers could eventually face hundreds of thousands of dollars in back taxes and penalties.

Foreclosures may also trigger a large tax liability for borrowers since a foreclosure is considered a sale for tax purposes. For example, suppose a business owner borrowed $800,000 to buy a $1 million piece of property that a lender foreclosed on and sold for $500,000.

If the borrower has no residual liability, this would constitute a $300,000 loan forgiveness — and thus, potentially taxable event — to the borrower, and the lender would be required to send the borrower a Form 1099 reflecting this amount. Even if the borrower has residual liability, there is a Form 1099C reporting requirement that occurs 36 months later.

One way borrowers can avoid this tax is by declaring bankruptcy, since debts compromised in bankruptcy are not taxable (though they are still reportable on a Form 1099C). This strategy is known as a pre-packaged bankruptcy.

There are several other exceptions to the general rule that debt forgiveness income is taxable. You should consult your tax professional or advise your borrower likewise if cancellation of debt occurs.