The Journal Fall 2011
My Home Is In Foreclosure, and I Have A $100,000 Capital Gain!?!
By Eric Wilson
A common misconception concerning properties in foreclosure is that the homeowner or investor being foreclosed upon will not suffer any tax ramifications. How could someone who is unable to make mortgage payments have taxable income after the lender forecloses on his/her property? Unfortunately, foreclosures are surprisingly common today as an aftermath of the recent housing meltdown, and adding insult to injury for the borrower undergoing the foreclosure, there are often unfavorable tax consequences that result from the process.
Prior to the real estate downturn in late 2008, many homeowners refinanced their homes to take advantage of historically-low interest rates. This also happened to be when housing prices were at their highest. The subsequent market crash resulted in prices plummeting while mortgage balances remained at their refinanced highs. In the unfortunate event of a foreclosure, homeowners may be faced with unexpected taxable gains.
To determine the tax implications of a foreclosure, the taxpayer must first establish if the mortgage on the property is recourse or non-recourse. This can be determined by contacting the taxpayer’s mortgage lender. In a non-recourse mortgage, the lender is only able to seize the borrower’s property and sell it to recover losses. To the extent the property is sold for less than the amount the borrower owed, the lender bears the risk of loss. In a recourse mortgage, the lender can pursue both the property and the borrower’s other personal assets in order to make the lender whole.
Once the type of mortgage is determined, the taxpayer can compute the gain or loss resulting from foreclosure. The gain or loss on foreclosure is computed the same way as a normal sale of property, which is the amount realized less the adjusted basis of the property. In a foreclosure involving a non-recourse mortgage, the amount realized is the mortgage balance. In a foreclosure involving a recourse mortgage, the amount realized is the lesser of the fair market value of the property or the mortgage balance. The adjusted basis is the same for both scenarios which is the original cost of the property plus additions less deductions (depreciation, casualty loss). If you find this confusing, you’re not alone.
THE BEST WAY TO GAIN AN UNDERSTANDING OF THESE RULES IS TO ANALYZE AN EXAMPLE:
Jimmy purchased a property for $400,000 with a down payment of $50,000 and a mortgage of $350,000. Home values rose over the next few years, and Jimmy refinanced his home for its full value at the time or $500,000. The housing recession hit Jimmy by surprise, and three years after he refinanced, his home was worth $430,000 and the mortgage was only paid down to $450,000.
What is Jimmy’s gain or loss if his home is foreclosed upon?
If the mortgage was Non-Recourse:
Fair Market Value = $430,000. Adjusted Basis = $350,000. Mortgage Balance = $450,000.
Jimmy would recognize a capital gain of $100,000. As stated earlier, the gain or loss will be the excess of the amount realized (mortgage balance of $450,000) over the adjusted basis of the property ($350,000). The fair market value is irrelevant when the mortgage on a property in foreclosure is non-recourse. Also, this type of foreclosure cannot result in income from the cancellation of debt.
If this property was Jimmy’s principal residence, he may be able to exclude the gain under Section 121. Section 121 is a common exclusion for homeowners who sell their principal residences in which they have lived in for at least two out of the past five years.
If the mortgage was Recourse:
Fair Market Value = $430,000. Adjusted Basis = $350,000. Mortgage Balance= $450,000.
Jimmy would recognize a capital gain of $80,000, and assuming the lender forgave the excess of the loan balance over the Fair Market Value (FMV) of the property, income from the cancellation of debt of $20,000. The fair market value is relevant when the mortgage on a property in foreclosure is recourse. When computing the gains or losses of a foreclosure involving recourse debt, the capital gain or loss must be calculated first. As discussed earlier, the gain or loss will be the difference between the amount realized and the adjusted basis on the property ($430,000 FMV minus $350,000 basis). In recourse situations, the amount realized is the lesser of the fair market value or the mortgage balance. Logically, however, the FMV of a foreclosed property will almost always be less than the mortgage balance, or the property owner could merely sell the property and pay off the mortgage in full.
Next, cancellation of debt income must be computed, if applicable, which is the excess of the mortgage balance less the fair market value of the property ($450,000 – $430,000 = $20,000). Cancellation of debt income is generated when the fair market value is less than the mortgage balance (i.e. the lender cannot pay off the entire mortgage by selling the property).
So one may be wondering, why does it matter if a foreclosure gives rise to only capital gain (as in the non-recourse example) or a mixture of capital gain and cancellation of debt income (as in the recourse example)? They both give rise to the same total gain, correct?
Yes, but with potentially different tax results. Depending on the situation, the cancellation of debt income may be excludible whereas the capital gain is not, or vice versa. For example, income from the cancellation of debt cannot be excluded by Section 121 (principal residence), but can be excluded by Section 108 (insolvency and other exclusions). To the contrary, a capital gain from the foreclosure of a qualifying principal residence may be excluded by Section 121, but not Section 108.
To really nail down an understanding of these concepts, assume Jimmy was really unlucky, and his house value dropped all the way to $330,000.
If the mortgage was Recourse, and Jimmy was really unlucky:
Fair Market Value = $330,000. Adjusted Basis = $350,000. Mortgage Balance= $450,000.
Jimmy would recognize a loss of $20,000 and income from the cancellation of debt of $120,000! The loss is calculated as the difference between amount realized and the adjusted basis ($330,000 FMV minus $350,000 basis). Despite the fact that Jimmy has recognized a loss on this aspect of the foreclosure he must still recognize cancellation of debt income to the extent the forgiven mortgage balance exceeds the fair market value of the property ($450,000 – $330,000 = $120,000).
If the property was personal-use property, the loss would be non-deductible and income from the cancellation of debt would not be excludible under Section 121, but could potentially be excludable under one of the other exceptions found in Section 121. If the property were an investment property, the loss would be capital.
To learn more about the tax implications of foreclosures, please contact your local WS+B advisor.
Section 408(b)(2) Is Effective January 1, 2012
By David R. Dacey, CPA, Partner
As a reminder, the U.S. Department of Labor, Employee Benefit Security Administration will require employee benefit plans to comply with the fee disclosure requirement rules under ERISA §408(b)(2) commencing January 1, 2012.
ERISA §408(b)(2) requires that service arrangements (and fees charged) for a covered plan be reasonable. Covered plans include pension benefit plans or pension plans within the meaning of ERISA Section 3(2)(A), but exclude simplified employee pensions, simplified retirement accounts and IRAs. One condition to meet this reasonable service arrangement and fee requirement (as part of the exemption from the prohibited transaction rules), is that certain fee disclosures are required to be made by covered service providers to the plan fiduciary, in writing, generally in advance of the contract.
Covered service providers generally include fiduciary service providers or investment advisers under the Investment Adviser Act of 1940. Also included are service providers performing banking, consulting, custodial, insurance, investment advisory, investment management, recordkeeping or third-party administration services. Service providers that will receive indirect compensation in connection with accounting, actuarial, appraisal, auditing, legal or valuation services to the plan are encompassed as well.
Covered service providers, pursuant to a contract or arrangement, charging $1,000 or more (including non-monetary gifts greater than $250) of direct or indirect compensation to the plan, are required to disclose in writing (as specifically defined in the rules):
- A description of the services to be provided to plan by the service provider.
- If applicable, a statement that the service provider (or its affiliates or subcontractor, hereafter “service provider”), will provide directly to the plan (or to an investment directly owned by the plan) services in the capacity of a fiduciary or an investment advisor.
- If applicable, a statement that the service provider (or its affiliates or service provider) will provide directly to the plan (or to an investment directly owned by the plan) services in the capacity of a fiduciary or an investment advisor.
- A description of services, payers and recipients of all: (1) direct compensation, (2) indirect compensation, (3) compensation paid among related parties of the service provider and (4) service termination fees received from the plan. Compensation paid directly by the plan sponsor is not subject to these requirements, unless the plan reimburses the plan sponsor.
- The manner in which the service provider will receive the compensation (e.g. based on billings or deducted directly from the covered plan’s accounts or investments).
- Recordkeeping service providers must disclose all direct and indirect compensation received from the plan. If estimates are provided, an explanation of the assumptions used to prepare the estimate of the services must be included.
If covered service providers fail to disclose the required information to the fiduciary, plan fiduciaries must follow certain protocols. These protocols could result in the fiduciary being required to notify the Department of Labor.
The preceding is general in nature and does not consider all aspects of the rules. These rules are very complex, and it is recommended that plan sponsors commence discussions with qualified ERISA legal counsel to better understand their responsibilities and the service provider’s disclosure requirements to them. This will become especially important as the new quarterly participant disclosure rules become effective on April 1, 2012.
Why You Should Audit Your Employee Benefit Plans Now!
Reducing unnecessary costs and routing out fraud from the healthcare system has been elevated to a high priority by the current administration. Earlier this year, Department of Health and Human Services (HHS) Secretary Kathleen Sebelius and U.S. Associate Attorney General Thomas J. Perrelli announced a new report showing that the government’s healthcare fraud prevention and enforcement efforts recovered more than $4 billion in taxpayer dollars in fiscal year 2010. Coupled with that report, HHS announced new rules authorized by the Affordable Care Act that will help to proactively prevent and fight fraud, waste and abuse in Medicare, Medicaid and the Children’s Health Insurance Programs (CHIP).
This crackdown by the government is commendable and long overdue. Enhanced auditing techniques, including data mining, have been deployed by the government to prevent fraud perpetrators and indifferent providers from overbilling for services and abusing the healthcare system.
THE NEW RULES IN THE AFFORDABLE CARE ACT SPECIFICALLY WERE DESIGNED TO:
Create a rigorous screening process process for providers and suppliers enrolling in Medicare, Medicaid and CHIP to keep fraudulent providers out of those programs. Types of providers and suppliers that have been identified in the past as posing a higher risk of fraud may have a more rigourous screening process.
Require a new enrollment process for Medicaid and CHIP providers.Under the Affordable Care Act, states will have to screen providers who order and refer to Medicaid beneficiaries to determine if they have a history of defrauding the government. Providers that have been kicked out of Medicare or another state’s Medicaid or CHIP will be barred from all Medicaid and CHIP programs.
Temporarily stop enrollment of new providers and suppliers. Medicare and state agencies will be on the lookout for trends that may indicate healthcare fraud —including using advanced predictive modeling software, such as that used to detect credit card fraud. If a trend is identified in a category of providers or geographic area, the program can temporarily stop enrollment as long as that will not impact access to care for patients.
Temporarily stop payments to providers and suppliers in cases of suspected fraud. Under the new rules, if there has been a credible fraud allegation, payments can be suspended while an action or investigation is underway.
While $4 billion dollars recovered is nothing to sneeze at, it is important to note that in an article in the National Review Online, the Cato Institute’s Michael F. Cannon pointed out that fraud against Medicare and Medicaid alone costs about $87 billion a year. Some experts predict fraud at ten percent or greater, yet the government’s results are based on auditing only a very small percentage of its claims.
Now for the real question: what does your Third Party Administrator (TPA) do to make sure you are not overpaying benefits in your self-insured plan? Do they do pre-screening of all new providers before adding them to their network? Are they comparing your claims payments by provider type to their book of business to determine potentially adverse and possibly fraudulent utilization patterns? Are they auditing your enrollees as provided in the Summary Plan Description? Are they flagging suspect providers and suspending payment instead of paying and pursuing? If they are not, your plan may not be doing any better than the Federal government in preventing inappropriate payments.
With healthcare now comprising a major portion of a company’s budget, CEOs and CFOs cannot afford to overlook the potential impact on their financial statements. If you have not audited your ERISA based benefit plan within the last two years, you need to do it as soon as possible. If you have audited your plan recently, did the report evaluate the impact of phantom discounts or R&C? Has it evaluated the fairness of benefit decisions and the veracity of clinical information supporting the underlying decisions to pay or deny a claim? Is there consistency in your benefit decisions across the board? Benefit plan audits are not as expensive as sponsors may think, but the consequences of not auditing your benefit plan can be more expensive than you expected, you just will not know it!
To Trade Show or Not To Trade Show
By Rhonda Maraziti, CMO
In today’s business climate where “doing more with less” is the current mantra, businesses are taking a hard look at all spending, particularly when it comes to marketing dollars. Part of the traditional marketing mix includes exhibiting at trade shows, which is generally a sizable investment in terms of both time and actual dollars. But are trade shows really worth doing? The answer to that depends on your ability to leverage all of the available benefits a trade show has to offer. Here are a few best practices to consider for maximizing the significant investment that comes with exhibiting at a trade show, reaping the rewards over the long-term:
CONDUCT YOUR DUE DILIGENCE FIRST
If the trade show you are considering is new to you, go as an attendee with one or two of your colleagues before committing to paying the exhibitor fees. Mill around the exhibitor hall. Observe the traffic. Talk to other attendees. This will help determine if that specific trade show is attracting your target audience. Also note if your competitors are exhibiting there already. Many times it is noticed when a company is not at a tradeshow, but their known competitors are clearly visible.
CREATE A PRE-SHOW PLAN
Often times as an exhibitor, you will be e-mailed an Excel spreadsheet prior to the show listing all of the registered attendees with their mailing addresses and sometimes their e-mail addresses. Create a postcard or e-mail campaign announcing your booth number and inviting attendees to visit you. Have fun and get creative developing ideas that will drive traffic to your booth (a valued prize or informative white paper). And don’t forget to spread the word via social media, as well.
CONSIDER BOOTH PLACEMENT
Exhibitors will usually receive a map of the vendor hall, indicating how the booths will be arranged by number. Take the time to look over the map, and select your top choices of booth location if given the option. Ideal locations would be by the main entrance of the hall where most traffic will be flowing in or out, or near the food area where people will be gathering most often.
MAXIMIZE SHOW TIME
Make the most of actually being at the show by networking with the crowd. Ensure there is ample coverage at your booth during peak traffic times, and have plenty of marketing materials and small giveaways available to share. Also consider providing a nice gift basket or prize drawing to gather business cards.
When traffic is light because the attendees are in a session, don’t be afraid to go talk to the other vendors, including your competitors. Like you, they are looking for something productive to do, and you might learn of some great tips and best practices to take back to the office with you. Also remember, vendors could be potential clients or referral sources. Take the time to get to know who else is exhibiting at the show with you.
DON’T OVERLOOK A POST-SHOW FOLLOW-UP CAMPAIGN
This is the area where most marketing efforts fall short. After the show is done, it quickly becomes a distant memory. Take the time to incorporate the names and contact info from the attendee list—along with the business cards from the prize drop—into your database of contacts. Send them your newsletters on a regular basis, keeping your firm’s name top-of-mind. Reach out to your new contacts, thanking them for stopping by the booth and invite them to lunch. This is the best way to build new relationships.
When considering exhibiting at a trade show, building a strategic plan behind the decision is the key to making it a successful investment. Take the time to get the most out of every opportunity a trade show can present.