Tax Consequences of a Deed in Lieu of Foreclosure

A deed in lieu of foreclosure is a transaction where a homeowner voluntarily transfers their property title to the mortgage lender. In exchange, the lender agrees to release the mortgage lien and cancel the loan, providing an alternative to a formal foreclosure. This arrangement allows the homeowner a more private resolution than a public auction. The lender also benefits by acquiring the property directly, avoiding the time and expense of a legal foreclosure.

Understanding Cancellation of Debt Income

When a lender forgives a portion of a loan, the Internal Revenue Service (IRS) may view that amount as income to the borrower, known as Cancellation of Debt (COD) income. The amount of COD income is the total outstanding mortgage balance minus the property’s Fair Market Value (FMV) at the time of the transfer. For example, if a loan balance is $300,000 and the home’s FMV is $250,000, the forgiven $50,000 is considered COD income.

This amount is taxable unless a specific exclusion applies. Both the COD income and any capital gain or loss from the property sale must be addressed when filing a tax return for the year of the transaction.

Exclusions for Cancellation of Debt Income

Even if a homeowner has COD income, it may not be taxable, as the tax code provides several exclusions. The primary exclusion for homeowners is the Qualified Principal Residence Indebtedness (QPRI) rule, which applies to forgiven debt on a main home. A property qualifies as a principal residence if it is the home where the taxpayer ordinarily lives most of the time. Through 2025, a taxpayer can exclude up to $750,000 of forgiven debt, or $375,000 if married filing separately. This only applies to acquisition indebtedness, which is debt used to buy, build, or improve the home, not home equity loans used for other expenses.

Another exclusion is for insolvency. A taxpayer is insolvent if their total liabilities are greater than the fair market value of all their assets just before the debt cancellation. The amount of COD income that can be excluded is limited to the amount by which the taxpayer is insolvent. For instance, if a taxpayer has $50,000 of COD income but was insolvent by $60,000, the entire $50,000 can be excluded.

A third exclusion applies to debts discharged in a Title 11 bankruptcy case. If the deed in lieu is part of a bankruptcy, the forgiven debt is not taxable income. The bankruptcy exclusion takes precedence over the QPRI or insolvency exclusions.

Calculating Gain or Loss from the Property Transfer

A deed in lieu of foreclosure is also treated by the IRS as a sale of the property, which can result in a capital gain or loss. The calculation depends on whether the loan is recourse or nonrecourse. A recourse loan allows the lender to pursue the borrower personally for unpaid balances, while a nonrecourse loan limits the lender’s remedy to seizing the property.

For a nonrecourse loan, the sale price is the full outstanding loan balance. For a recourse loan, the sale price is the property’s Fair Market Value (FMV), and any loan amount forgiven above the FMV is treated as COD income.

The gain or loss is calculated by subtracting the property’s adjusted basis from the sale price. The adjusted basis is the original purchase price plus the cost of significant improvements. A positive result is a capital gain, while a negative result is a capital loss, though losses on personal residences are not deductible.

A homeowner may be able to exclude a capital gain under the Section 121 exclusion. This allows a taxpayer to exclude up to $250,000 of gain ($500,000 for certain married couples) from the sale of a main home. To qualify, the taxpayer must have owned and used the property as their principal residence for at least two of the five years before the sale. This gain exclusion is entirely separate from the QPRI exclusion for canceled debt.

Required Tax Reporting and Documentation

The reporting process begins when the lender issues Form 1099-C, Cancellation of Debt, which reports the amount of forgiven debt to both the taxpayer and the IRS. This form provides the amount of debt canceled and the property’s fair market value.

To claim an exclusion for any COD income, the taxpayer must file Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, with their tax return. On this form, the taxpayer specifies which exclusion they qualify for, such as the QPRI or insolvency exclusion.

The sale portion of the transaction is reported on Form 8949, Sales and Other Dispositions of Capital Assets, which carries over to Schedule D, Capital Gains and Losses. Any claim for the Section 121 gain exclusion is also reported on these forms.