Mobility Law Blog: Posts

Debt Forgiveness in Short Sales May Be Taxable

Peter Scott — Sun, 20 May 2012 18:29:16 GMT

Body:

In Short:

Although the Internal Revenue Code currently provides a break for taxpayers whose home mortgage debt is forgiven,

that break only applies to debt incurred to buy or improve a principal residence, and not to home equity lines of

debt or cash-out refinances. It is also scheduled to expire at the end of 2012. Because of the possible expiration, companies may want to try to close as many short sales as possible before the end of 2011.

The Full Story:

Today’s tax quote: “The first 9 pages of the Internal Revenue Code define income; the remaining 1,100 pages spin the web of exceptions and preferences.” Warren G. Magnuson

Although the Code has expanded a bit since Senator Magnuson’s remark (he’s currently off by more than 1,000 pages), it remains a constantly expanding compendium of special provisions. One of those is of considerable value to

today’s underwater homeowners, and to transferees who must engage in a short sale.

However, despite the 2007 addition to the Internal Revenue Code of special rules that eliminate taxability of the

forgiveness of some mortgage debt, not all mortgage debt is covered, there are issues that arise, and the provision

is scheduled to expire at the end of 2012 if not extended by Congress. This Mobility LawBlog post is intended to

remind Worldwide ERC members of the rules that apply, and to suggest that settlements of short sales near the end of

the year may need to be accelerated to take advantage of the expiring exclusion.

The basic rules are these. Relief from debt generally is taxable under section 61(a)(12) of the Internal Revenue

Code. This is usually referred to as “cancellation of debt” (COD) or “discharge of indebtedness” income, and it is

taxable whether debt relief is full or only partial. However, if the debtor is in bankruptcy or insolvent, the

cancellation of debt is not taxable. Rather, the debtor reduces other tax attributes or the basis of other assets by

the amount of debt relief. Further, accrued interest that is forgiven on a home mortgage ordinarily does not result

in tax liability, because section 108(e)(2) excludes forgiven debt the payment of which would have resulted in a tax

deduction.

The tax issues that arise will also trigger income tax consequences in many of the states, particularly those that

follow the Internal Revenue Code.

The lender is required by section 6050P to report the amount of cancellation of indebtedness income to the IRS and

the borrower. Form 1099-C is used for this purpose.
However, effective for debt cancelled between January 1, 2007 and December 31, 2009, the “Mortgage Forgiveness Debt Relief Act of 2007” amended section 108 to provide an exclusion for “qualified principal residence indebtedness”.

See section 108(a)(1)(E). This exclusion was extended through 2012 by the “Emergency Economic Stabilization Act of 2008.” Section 108(h)(2) defines qualified principal residence indebtedness as up to $2 million of mortgage debt

incurred to acquire a principal residence ($1 million for a married person filing separately). Section 108(h)(3)

limits the exclusion to discharges directly related to either a decline in value of the residence or the financial

condition of the taxpayer.

While this provision alleviates much of the tax pain associated with forgiveness of home mortgage debt, it does not apply to home equity loans (which are not “acquisition indebtedness”), nor would it apply to any increment of a

refinanced mortgage that was incurred to take cash out of the home rather than to pay for home improvements. For

example, if the original mortgage was $300,000, the home increased in value to $500,000, and the borrower refinanced

into a $400,000 mortgage with $100,000 of cash out, only the original $300,000 mortgage amount would qualify for

exclusion if cancelled. Further, under section 108(h)(4) it is the additional non-qualifying $100,000 of debt that

is considered cancelled first. So if there is a short sale for $300,000, and $100,000 of the refinanced $400,000

mortgage is cancelled, the entire $100,000 of cancelled debt is taxable income.

The rule limiting relief to acquisition debt, and not home equity loans or lines of credit, can also come into play

when negotiating short sale debt relief. Ideally, it would be preferable for all of the forgiveness to be allocated

to the principal debt, with the home equity line paid in full. If the debts are with the same lender, it is possible this could occur as part of negotiations, but unfortunately it is rare. Similarly, if there is a choice between forgiveness of unpaid interest and forgiveness of other mortgage debt, forgiveness of interest generally is preferable because it is not taxable without regard to the special rules for mortgage debt.

Assuming the relief provision for cancelled home mortgage debt does not apply, remember that the taxpayer can still

avoid income tax if the taxpayer is insolvent. In some instances the short seller may in fact be insolvent, and

therefore not liable of tax on the debt forgiveness. Insolvency is measured immediately before the forgiveness, and many taxpayers may be insolvent at that point in the sense that their liabilities exceed their available assets.

However, under current judicial authority retirement assets such as IRA’s and 401(k)’s count as assets in measuring

insolvency, even thought they are beyond the reach of creditors. Consequently, many short sellers may still not be

insolvent under the law.

When it enacted the mortgage debt exclusion provision, Congress made no changes to the requirement to report COD income on Form 1099-C. Therefore, lenders continue to compute and report the full amount of COD income, even if all or part of it can be excluded by the borrower. The borrower reports the COD income, but claims the exclusion of Form 982 filed with the tax return.

In the short sale scenario, computation of COD income ordinarily is straightforward. However, IRS recommends that

recipients of Form 1099-C examine it closely to make sure the lender has correctly calculated and reported the

amount of debt forgiveness, and contact the lender immediately if there is any dispute.

Finally, there can be questions as to whether the debt was in fact cancelled. If the lender continues to carry the

debt on its books even after the borrower has surrendered the property, and continues to try to collect it, there is

no COD income. Generally, lenders do write off such debts, unless they feel there is a strong likelihood of

collecting something from the borrower. Receipt by the borrower of Form 1099-C should be taken to mean that the

lender has in fact written off the debt.

As noted earlier, the special relief provision for home mortgage debt will expire at the end of 2012. There are

several bills pending in Congress to extend the relief (see, for example, H.R. 4250 and S. 2250), and one bill would

even extend the relief to other circumstances, such as relief provided under the federal HAFA program (see H.R.

4290). However, it is unlikely that any extension will occur, if at all, until after the November elections. Consequently, parties involved in short sales will be well-advised to try to achieve closing of the short sale before the end of 2012 just in case the provision is not eventually extended.

The Internal Revenue Service has a number of resources that relate to the tax consequences of foreclosures that are

accessible on its website at www.irs.gov. These include IRS Tax Tip 2012-39 (February 28, 2012) “Mortgage Debt

Forgiveness: 10 Key Points (http://www.irs.gov/newsroom/article/0,,id=254930,00.html.) and a number of “Questions and Answers on Home Foreclosure and Debt Cancellation.” IRS Publication 4681, “Cancelled Debt” etc. also discusses this topic, as does IRS Publication 544, “Sales and Other Dispositions of Assets.”

Finally, some advice for companies assisting transferees with short sales: Do not provide tax advice to those transferees. As demonstrated by the discussion above, this is a very complicated area of the tax law, and the prudent action is simply to suggest that transferees consult their own tax advisors.

Posted by Peter K. Scott

Category: Home Purchase programs;Loans/Mortgages;Mortgage/Foreclosure

Published: 5/25/2012 9:54 AM

Ministers Renew Mandate of Financial Action Task Force through 2020

Tristan North — Sun, 20 May 2012 16:34:36 GMT

Body:

In Short:

The Ministers of the Financial Action Task Force (FATF), the inter-governmental body responsible for developing standards against illegal financial activity, have renewed the mandate for the organization through 2020. The focus of the FATF is to develop standards and make recommendations to its member countries on ways to combat money laundering and the financing of terrorist activity and proliferation of weapons. The FATF released its most recent set of recommendations in February and in 2013 will be issuing an updated report card on how each country has fared in implementing past recommendations. Worldwide ERC© is monitoring the implementation of the recent recommendations as well as the development of future recommendations to ensure that the FATF policies do not place any unnecessary additional burden on employee mobility.

The Full Story:

The Financial Action Task Force (FATF) was established at the G7 Summit in 1989 as an inter-governmental body to address legal, regulatory and operational measures to combat money laundering. In 2001, the mandate of the FATF was expanded to include thwarting the financing of terrorist activity. The FATF is comprised of 34 countries and 2 regional organizations including the United States, European Union, Brazil, Canada, China, India, Russia and South Africa. The 36 members of the FATF must agree to renew the overall mandate for the organization every several years which they did in April in Washington, DC.

In addition to the 36 members of the FATF, the organization relies on a network of eight FATF-Style Regional Bodies (FSRBs) which encompass another approximately 160 countries. Each of the members of the FATF and the FSRBs has committed to adhere to the standards established by the FATF, although the FATF acknowledges that not every country will have the capacity and ability to implement all of the recommendations. For a complete list of countries involved with the FATF, please go to:http://www.fatf-gafi.org/countries/.

The recommendations of the FATF are recognized as the global standard to combat illegal or terrorist activity involving the world financial system. The FATF first issued recommendations in 1990 with revised recommendations made in 1996, 2001, 2003 and then in February of this year. There are 40 recommendations on combating money laundering that are reviewed and revised periodically as well as nine special recommendations on thwarting the financing of terrorist activity. After the FATF issues recommendations, it then monitors the progress of the implementation by each country and issues a report card which includes an update on a handful of countries each year. The FATF does not have enforcement authority of illegal activity within the financial system which is the role of Interpol or the law enforcement or financial oversight agency of that country.

The FATF recommendations are for the most part broad and just intended as a roadmap so that countries can put into place measures to:

identify the risks, and develop policies and domestic coordination;
pursue money laundering, terrorist financing and the financing of proliferation;
apply preventive measures for the financial sector and other designated sectors;
establish powers and responsibilities for the competent authorities (e.g., investigative, law enforcement and supervisory authorities) and other institutional measures;
enhance the transparency and availability of beneficial ownership information of legal persons and arrangements; and
facilitate international cooperation.

There are instances where the recommendations are very explicit but it is up to each country to determine the details of the measures and what specific action it will take to implement the recommendations. For a list of the February 2012 recommendations, please go to: http://www.fatf-gafi.org/topics/fatfrecommendations/documents/fatfrecommendations2012.html.

While the recommendations of the FATF have the most impact on financial institutions, there are implications for real estate agents as well as non-financial institution businesses that have an international presence or dealings. For instance, when dealing with a foreign financial institution as part of the process to transfer an employee, the institution may require additional information about your organization or employee in order to satisfy reporting requirements for that country. The FATF recommends that transactions involving $15,000 or more warrant special due diligence on the part of the financial institution.

For many of the reporting and recordkeeping requirements under the recommendations, the FATF applies the same standards to real estate agents involved in domestic or international real estate transactions. These requirements are not new and are typical practice in the United States. For instance, the FATF recommends that real estate agents maintain all transaction records dealing with the sale or purchase of a property for five years so that they can comply quickly with requests from law enforcement authorities. The FATF issues guidance periodically on specific pieces of its recommendations which it did in 2008 for real estate agents. To access a copy of the “FATF Guidance on the Risk-Based Approach for Real Estate Agents”, please go to: http://www.fatf-gafi.org/topics/fatfrecommendations/documents/fatfguidanceontherbaforrealestateagents.html.

Companies relocating employees to countries on the FATF “High Risk and Non-Cooperative Jurisdictions” List may encounter additional reporting requirements or face pushback from U.S. banks in dealing with financial institutions based in countries on the list. The list includes Bolivia, Cuba, Ethiopia, Ghana, Indonesia, Kenya, Myanmar, Nigeria, Pakistan, Sao Tome and Principe, Sri Lanka, Syria, Tanzania, Thailand and Turkey with the TAFT identifying North Korea and Iran as being substantial risks for money laundering and terrorist financing. The TAFT recommends that companies and financial institutions exercise special care when dealing with parties in those countries. This could complicate matters for oversees employees who have an account or credit card with a financial institution in one of these countries.

We will continue to monitor the implementation and development of recommendations by the TAFT as well as the impact of TAFT policy and reports on employee mobility.

Posted by Tristan North

Category: Non US Business Law News

Published: 5/21/2012 7:34 AM

Bill to Restrict Taxation of Workers Temporarily in a State Passes House

Peter Scott — Thu, 17 May 2012 14:44:48 GMT

Body:

In Brief:

Legislation (H.R. 1864) that would prohibit states from taxing workers temporarily in the state, or requiring withholding by the employer, until the employee had worked there for more than 30 days has been passed by the U.S. House, and now moves to the Senate. Although prospects for the legislation in the Senate are uncertain, if enacted this year it
would go into effect on January 1, 2014.

The Full Story:

Advocates of standardizing what is now a very confusing patchwork of conflicting state rules concerning when workers become taxable, and subject to withholding, when working temporarily in a state scored a major victory on May 15, 2012, with passage by the House of Representatives of H.R. 1864, the “Mobile Workforce State Income Tax Simplification Act.” The bill can be accessed here: http://www.gpo.gov/fdsys/pkg/BILLS-112hr1864eh/pdf/BILLS-112hr1864eh.pdf.

Versions of this legislation have been introduced every year for several years, but had never achieved passage by either chamber of Congress. The bill now moves to the Senate, where its prospects are uncertain. However, it is encouraging that passage in the House was on a bipartisan voice vote, with little expressed opposition.

Under the bill, a worker would continue to be fully taxable in his or her state of residence on all income, but would not be taxable in any other state unless the employee worked there for more than 30 days during the year. Consistent with that standard, the employer would not have to begin withholding in the temporary assignment state until the employee had worked there for 30 days.

Currently, employers face a different rule in every state. According to testimony submitted by the Council on State Taxation (COST) at a hearing of the Subcommittee on Courts, Commercial and Administrative Law of the House Committee on the Judiciary held on May 25, 2011, more than half the states technically require withholding to begin on the first day an employee earns wages there, while others have either time periods before withholding must begin, or minimum wage amounts before withholding must begin, or some combination of both. Similarly, the rules for when an employee becomes taxable also vary from state to state, and are not always consistent with the rules requiring withholding.

As a practical matter, this forces many employers who simply cannot keep up with or comply with different rules in multiple states to adopt “rules of thumb,” under which they arbitrarily begin state withholding after some standard period such as two weeks, or some standard amount of wages, such as $3,000. This occasionally leads to a dispute with a state.

H.R. 1864 would remedy the inconsistency by legislating a standard 30-day period both for taxability and withholding. There would be no income threshold. However, the 30-day limitation would not apply to entertainers, athletes, and other “public figures,” who generally are paid on a per event basis and would remain fully taxable in the state in which the income was earned. The legislation would define a “day” as any day on which the employee performs “more of the employee’s employment duties” in the state than in any other state, but would allocate all of the services to the nonresident state on any day in which the employee performs duties in both a nonresident state and the state of residence. Consequently, if an employee who lives in Michigan worked in the morning in Illinois, and in the afternoon traveled to Iowa and worked there, both employer and employee would have to determine in which nonresident state (Illinois or Iowa) more of the employee’s duties occurred. However, the bill also provides that the portion of the day devoted to travel will not count in making the determination.

One potential pitfall in the way the bill is constructed is that once the employee crosses the 30-day threshold, withholding would have to take place for all of the 30 days already worked there. A number of groups (for example, the AICPA) have testified that this rule will result in unfair cash-flow issues for employees, and should be changed to permit withholding adjustment over time, or to eliminate the retroactive withholding.

Not surprisingly, the states have consistently opposed this legislation. Although analysis by COST suggests that the overall revenue loss to the states would be minimal, the legislation would shift revenue from some aggressive states (such as New York) to others, so that there would be winners and losers. Moreover, the states object to the loss of control over their own tax systems, and to the some of the standards in the bill. For example, although they view the 30-day standard as an improvement over prior versions of the legislation that would have imposed a 60-day standard, as testified to by the Federation of Tax Administrators the states still think the 30-day threshold is too long. Moreover, they think the bill should also contain some minimum wage threshold as an alternative. For example, an employee might become taxable once he or she had been working an aggregate of 20 days in a state, or earned $20,000 there. Otherwise, high-wage employees would be able to earn very large amounts of money in a state before becoming taxable there.

The states also object to the standard in the bill for how employers would determine whether an employee had become taxable in a state. H.R. 1864 provides that an employer is permitted to rely on an employee’s determination of time in a state unless the employer has actual knowledge of fraud by the employee, and is not required to use its own records for this purpose even if uses them for other purposes, except under limited circumstances in which it maintains a “time and attendance system which tracks where the employee performs duties on a daily basis.” According to the FTA, the fraud standard is too weak, and the employer should not be able to rely on the employee’s determination if it has actual knowledge that the determination is incorrect, whether or not there is fraud. Further, it believes that if the employer maintains records of where the employee is, it should be required to use them.

There are also issues with the definition of a “day.” The FTA believes a day should be defined as any part of a day in which the employee performs services in a state, without the necessity to determine whether those services were the majority of services during that day.

There are other issues, as well, such as the treatment of income from bonuses, stock options, and other deferred compensation.

In the states, the Multistate Tax Commission (MTC) has been working on a model statute that it maintains would provide consistency if adopted by the states. However, such model statutes do not have to be adopted by any state, and can also be modified by any state adopting them, so it is unlikely that any consistency would actually result from the effort.

Despite some continuing issues with the legislation, passage by the full House marks a milestone in its multi-year evolution, and Worldwide ERC hopes that this time around it will finally receive favorable attention in the Senate, since it would greatly simplify the task faced by ERC members trying to track and properly withhold on employees working in diverse locations. However, Worldwide ERC members should not expect immediate relief even if the legislation passes this year. The law as written would not take effect until the second full year after its passage, which would be January 1, 2014 if the law is enacted during 2012.

Posted by Peter K. Scott

Category: State taxes;Withholding/reporting/gross-up;Tax legislation

Published: 5/18/2012 8:31 AM