A borrower may be able to avoid foreclosure through a deed in lieu whereby the homeowner agrees to transfer the title of the property to the lender. In return, the lender will release the borrower from all obligations from the mortgage. This is beneficial to the borrower because the negative effect of the deed in lieu on his credit score is much less than that of a foreclosure. Meanwhile, the lender benefits because he is able to forgo the expenses and the effort that are usually needed for a formal foreclosure.
However, a borrower who is able to get a deed in lieu will be liable for taxation on the cancellation of indebtedness or COD income. The tax results would be based on whether the loan is classified as a non-recourse loan or a recourse loan. This classification is specified in the loan documents that were originally signed by the lender and borrower. Basically, if the only option of the lender is to get back the property when the borrower defaults, then it is a non-recourse loan. However, if the lender can go after the borrower to collect any shortfall when the property is sold, then it is a recourse loan. A lender has to submit a Form 1099-C to the IRS in the case of a shortfall in a recourse loan where a deed in lieu has been granted. This is known as the borrower’s COD income.
In the case of a non-recourse loan, the IRS will consider the tax consequences of the deed in lieu as if the borrower had sold the property. It the current market value of the property is less than what is owed, the borrower will have a personal loss but this is not tax deductible. On the other hand, if the value of the property is greater than the outstanding loan, the borrower will have a gain that may not be taxed if he is able to comply with IRC Sec. 121 two-year residency requirement. In the case of a recourse loan, the situation is similar to the non-recourse loan except that the borrower will also be taxed for COD income if the value of the property is less than what is owed. Ordinary income rates will be applied for the COD income.