R&B artist R. Kelly took a huge hit to his finances this week when his 20,000 square foot dream home was auctioned for less than a million dollars. The home, which Kelly had built in 1997, was subject to a $3.5 million mortgage.
R. Kelly, whose real name is Robert Sylvester Kelly, has been recognized by the Recording Industry Association of America (RIAA) as one of the best-selling music artists in the U.S. Sometimes called the King of R&B, Kelly has produced ten albums, collaborated with stars like Jay-Z and Kanye West and was nominated for a Grammy for penning Michael Jackson’s hit single, “You Are Not Alone.”
Despite his star status – and selling more than 38.5 million records in the U.S. alone – Kelly’s bank claims that he hasn’t paid the mortgage on his Illinois mansion. The bank attempted to push the house into foreclosure in 2011 but Kelly was able to stave off the proceedings while he tried to sell the home on his own. Those efforts weren’t successful and the home sat on the market for a year before the bank re-upped efforts to foreclose this year. On Monday, the Illinois home was finally sold at auction for $950,000; the new owner now has claim to six bedrooms, eight baths, an indoor pool, theatre room, and a private lake.
That kind of financial loss has to hurt. Can Kelly claim the hit on his taxes? Unfortunately, he can’t if he considers the Illinois mansion his primary residence.
A foreclosure is considered a disposition for federal income tax purposes and is treated as a sale. While you pay tax on the capital gain on the sale of a primary residence (thankfully subject to an exemption), you may not deduct a loss on the sale of a primary residence. Different rules apply for losses when the property is held for business or investment purposes.
The tax consequences of a foreclosure, however, don’t end there. Generally, for federal income tax purposes, when you borrow money and it is later cancelled, discharged or forgiven, you have to report and pay tax on the amount which was cancelled, discharged or forgiven. There are a few exceptions to this rule. They are:
- Bankruptcy. If the debt is discharged as a result of a chapter 11 bankruptcy, the discharge is not considered taxable income. Be careful. Merely filing for bankruptcy is not enough: only the debt which was discharged as a direct result of the bankruptcy proceedings is exempt under this exception.
- Insolvency. If you are insolvent at the time the debt is cancelled, some or all of the cancelled debt may not be taxable to you. For this purpose, you are considered insolvent if, before the cancellation, your total debts are more than the fair market value of your total assets. As a general rule, assets include everything you own even if they are pledged to others as collateral or are otherwise exempt from creditors (so yes, you must include your pension and retirement accounts).
- Certain farm debts. This is exactly like it sounds like: if you incurred the debt while operating a farm and meet certain other specific criteria, your cancelled debt will not be considered taxable income.
- Non-recourse loans. A non-recourse loan is one that is secured by collateral. When a non-recourse loan isn’t repaid, the lender can take the collateral but cannot chase the borrower for additional funds, even if the value of the collateral doesn’t cover the amount of the loan. In other words, there is no personal liability for the loan. The classic example of a non-recourse loan is a simple mortgage (if you sign a personal guarantee in addition to the mortgage, that changes the nature of the loan). As such, forgiveness of a non-recourse mortgage resulting from a foreclosure does not result in cancellation of debt income. But a word of caution: refinanced loans and home equity loans tend to be recourse loans. That would have a different result.
All of that said, the Mortgage Forgiveness Debt Relief Act of 2007 generally allows taxpayers to exclude from income from the discharge of debt on their principal residence. That would include mortgage debt which is forgiven as a result of foreclosure, as well as debt restructuring, short sale or deed in lieu of foreclosure, so long as the debt is associated with the purchase, building or improvement of your main home and even if that debt is considered recourse debt. Up to $2 million of forgiven debt is eligible for this exclusion ($1 million if married filing separately). The Mortgage Debt Relief Act of 2007 applies to mortgage forgiveness in the years 2007 through 2013; it was extended by a year under the recent tax deal.
It’s tough all around these days for many taxpayers – even pop stars. Fortunately, relief is available to mitigate some potentially ugly tax consequences. The applicable rules can be fairly difficult to navigate and are facts and circumstances dependent. You need to be sure to file the right forms, fill out the applicable worksheets and meet important deadlines. If you’re facing foreclosure, short sale or other mortgage-related issues, be sure to consult with your tax professional.
