IRS Real Property Foreclosure and Cancellation of Debt Audit Technique Guide: A First Look

H. Wayne Cecil, PhD, CPA, and Teresa King, PhD, CPA
Published Date:
Jul 1, 2015

The IRS publishes Audit Technique Guides (ATG) to assist its examiners in performing appropriately focused audits of federal income tax returns. ATGs, which highlight special areas of concern, are also publicly available to tax preparers for use in documenting and taking appropriate positions on income tax returns. On Mar. 11, 2015, the IRS completed the Real Estate Property Foreclosure and Cancellation of Debt Audit Technique Guide. The ATG, developed in response to the proliferation of real property foreclosures and debt cancellations, provides a clear explanation and concise examples of the related federal income tax consequences. 

Parts of the ATG

The ATG is divided into separate chapters addressing specific issues. After an overview (chapter 1) followed by types of debt (chapter 2), it includes chapters on income from discharge of indebtedness (chapter 3), tax attribute reduction (chapter 4), rental real estate property (chapter 5), abandonments (chapter 6), Form 1099-A and Form 1099-C (chapter 7), community and common law property (chapter 8), audit strategies (chapter 9), the rehabilitation credit and IRC section 469 (chapter 10), and the low-income housing credit (chapter 11). The ATG is 72 pages long and utilizes 36 examples to aid readers in understanding key issues. 

Chapter 9 of the ATG presents a concise summary of IRS audit strategies discussed in earlier chapters. The list summarizing the audit strategies is as follows:

  • During the initial interview, ask the taxpayer questions to establish the facts and circumstances that led to the disposition or loan modification. If CODI (Cancellation of Debt Income) was excluded from income, establish whether the taxpayer qualified to exclude income under the exclusion.
  • Pull property records upon receipt of a case to identify property owned and disposed of and all loans associated with the property.
  • A reconciliation of the Information Returns Processing (IRP) to the return is a required Minimum Income Probe step.
  • (Internal Revenue Manual (IRM) Nonbusiness returns and IRM Business returns). During this reconciliation, review the IRP for issuance of a Form 1099-A and/or Form 1099-C. This will help to identify whether or not an income issue exists, because the taxpayer may not have reported a foreclosure or other type of disposition on the tax return.
  • Request the taxpayer’s calculation of CODI and gain/loss of a property. Ask about any large, unusual, or questionable items and ask for supporting documentation when warranted.
  • All mortgages should be included in the calculation of gain/loss and CODI. (Note: lenders, erroneously, do not always issue Forms 1099-C on all mortgages, especially second mortgages, or where the second mortgage is from a different lender). Review property records and consider looking at prior years’ IRP for Forms 1098. These documents will identify whether the debt was being paid and, possibly, whether the debt should be considered in the disposition calculation(s).
  • Review the final HUD-1 for loan modifications and dispositions. There are a few federal, state, and lender incentives that the taxpayer may qualify for. Identify whether a loan modification incentive received is taxable. For dispositions (e.g., short sales), a taxpayer may receive funds to cover relocation expenses. This may be listed on the HUD-1 as “relocation assistance”. This amount generally is taxable and should be included in the sales price on Schedule D or Form 4797.
  • When loan or sales information is in question, request the final HUD-1 from the lender or search public property records for recorded loan information, foreclosure notices, grant deed and/or title transfer for the disposition. The taxpayer might not have a copy of these documents if the home was foreclosed or disposed through a deed in lieu of foreclosure. These documents will identify pertinent information such as, the sales amount, date of title transfer, identifiable event, etc.
  • Note that the final HUD-1 may not list the total debt owed at disposition. The HUD-1 will show the sales price and the amount of the proceeds that will be applied towards the loan balance right before the sale. You will need to add the amount forgiven to the sales price to identify the approximate amount owed right before the disposition. Also, review property records, the last monthly loan statement, loan documents, and/or other documents to identify the loan balance owed right before the disposition.
  • Request purchase and refinance documents to determine the adjusted basis. Ask the taxpayer how the funds were used if the property was refinanced. Any amount used for personal purposes is not qualified indebtedness under the principal residence, farm, and real property business exclusions.
  • Request a copy of the insolvency calculation. Ask about any questionable items and request supporting documentation when warranted. Refer the taxpayer to Publication 4681 to complete the insolvency worksheet if insolvency is claimed during the audit. The insolvency exclusion is not an election and can be utilized even during an examination.
  • As part of the insolvency calculation, look for any liabilities that should have a corresponding asset. For example, if a car loan is listed, the fair market value of the vehicle should be listed under assets, unless the vehicle was repossessed.
  • Generally, mortgage lenders will conduct an appraisal of the property during a short sale process. Therefore, a comparison of the fair market value on the Forms 1099-A and/or 1099-C with the taxpayer’s insolvency calculation can be done to identify any differences. If you do identify any differences, request that the taxpayer explain how they determined the fair market value of the property particularly if the difference puts the taxpayer in an insolvent position.
  • Sometimes taxpayers attempt to convert their principal residence into rental real estate property right before it forecloses. Then, the losses and non-deductible personal expenses (e.g., property insurance) are deducted as passive losses and deductions, respectively. Determine why the taxpayer converted the residence to a rental and whether it was formally the taxpayer’s principal residence or second home and the resulting tax consequences. Evaluate whether the conversion was temporary or a permanent conversion to a valid rental activity.
  • Non-issuance of a Form 1099-C does not relieve taxpayers of their responsibility to include CODI in income. Identify all loans on the property by reviewing IRP and property records. All loans should be considered in the CODI and gain/loss calculations.
  • Consider state foreclosure laws for the state where the property is located. For example, at times taxpayers are not issued Form 1099. The state law will help to determine whether the lender forgave any debt.
  • When CODI, Form 4797 gain/loss or Schedule D gain/loss, and Schedule E gain/loss for all years are netted and result in a loss, consider whether the taxpayer is “poorer” by that amount. If the taxpayer could not afford to sustain that loss then how did he/she fund the losses (e.g., other debt, current year income, or other assets)?

Important Takeaways

A first look at the ATG results in two noteworthy takeaways. First, each situation (foreclosure, deed in lieu of foreclosure, short sale, and abandonment) is unique; accordingly, there are no simple conclusions with respect to the proper federal income tax determination. The ATG notes that the facts and issues are situation specific, and a single fact can change the determination of the proper amount of any federal income taxes. A second important takeaway is that the proper federal income tax consequences depend upon applicable state laws.

Chapter 8 presents a review of the basics of community and common law property systems. It states that in “Aquilino v. United States, 363 U.S. 509(1960) and Morgan v. Commissioner, 309 U.S. 78(1940), the court decided that federal law determines how property is taxed, but state law determines whether and to what extent a taxpayer has ‘property’ or ‘rights to property’ subject to taxation” (ATG p. 60). The taxpayer’s state-created rights in real property determine the assessment of any federal income taxes. Forty-one states have adopted common law property systems, and nine have adopted community property systems (ATG p. 61). The ATG notes the importance of IRS personnel properly addressing and seeking legal counsel regarding specific state law issues. 

The ATG provides very useful and helpful insights for tax preparers dealing with the reporting of real property foreclosures and debt cancellations. It makes preparers aware of the most likely steps followed by revenue agents in an audit, thus allowing preparers to address in advance questions commonly asked and to preserve documents that might be requested. Yet, it is important to remember that the ATG is not an official IRS interpretation of the related federal income tax laws. In fact, the disclaimer on its cover states:

NOTE: This document is not an official pronouncement of the law or the position of the Service and cannot be used, cited, or relied upon as such. The Guide is current through the publication date. Since changes may have occurred after the publication date that would affect the accuracy of the document, no guarantees are made concerning the technical accuracy after the publication date.

CecilH. Wayne Cecil, PhD, CPA, is a professor of accounting at Florida Gulf Coast University in Fort Myers, Florida. He can be reached at 239-590-7307 or


KingTeresa King, PhD, CPA,
is a professor of accounting at Georgia College & State University in Milledgeville, Georgia. She can be reached at


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