The Economic Gain Doctrine

In this story at CNN Money, Les Christie discusses the tax consequences of debt forgiveness and foreclosure.  Sometimes, but not always, you can be liable for the balance of your mortgage if it is forgiven in the course of a foreclosure or deed in lieu.  In short, if you lose your house, you could owe taxes on it as well.

It doesn’t seem fair, and there are some safeguards against it, but the concept behind this double whammy is simple.  If I remember correctly, and that is questionable, the concept is known as the doctrine of economic gain.  Plainly put, if you have an economic gain, the government taxes you on it.  This is the basis of the income tax in a nut shell.  But, how can this lead to you owing taxes on a loan?  I’ll explain.

First, the basics.  When you go to work and earn a paycheck, that is income to you; it’s an economic gain.  You received money, you got to keep the money, you pay taxes on the money (remember the order of events, it becomes important).  Most people understand this and are OK with the concept.  Now, unlike normal income, loan money is not taxed.  It is not an economic gain because you have to pay it back.  You received money, you did not get to keep the money, you do not pay taxes on the money.  Since you have to pay it back, loan money is never really your money, so it can not be an economic gain.

The reason why forgiven debt can be taxed is because the borrower retains use of the money.  You received the money, you got to keep the money, you pay taxes on the money.  When debt is forgiven, it transforms from “never really your money” into “income” or economic gain.  It doesn’t matter that the borrowed money was used to buy a TV or a car or a house, the borrower whose debt is forgiven has retained the use of the money.

In a normal, appreciating, real estate market, a foreclosed home can be sold to cover the balance of a debt.  In our real estate market, this is not always the case.  Often, repossessed homes do not cover the loan balance.  Other scenarios that could result in a remaining loan balance are short sales and deeds in lieu.  The remaining loan balance, if forgiven, could become income to the borrower.  If this is taxed, our IRS will take its payment in cash.  That is a tough hurdle for someone who just lost their home and likely doesn’t have much money saved.

There is hope.  One way to avoid paying taxes on forgiven debt is to reaffirm it.  You can tell the bank you want to repay the difference.  Of course, you will have to continue making payments on the remainder, but it may be easier than coughing up the cash to make a big lump-sum payment of taxes.  Bear in mind that there are consequences for every action.  It may be worth while to ask questions if paying the mortgage is getting tough.  A tax or mortgage professional should be able to explain the tax impact of a specific short-sale, foreclosure or deed in lieu scenario.