Is There a Tax Liability for a Deed-in-Lieu in Arizona?

Deficiency Judgments

A deficiency judgment is a court judgment against a borrower for the difference between the market value of a property when it is foreclosed, sold through a short sale or transferred to the lender via a deed-in-lieu of foreclosure. State law determines whether a lender has the right to file for a deficiency judgment against you.

Arizona Deficiency Rules

Arizona state law prevents lenders from getting a deficiency judgment against you if you took out the defaulted loan to purchase a one- or two-unit residential property. The state of Arizona classifies these loans as non-recourse, meaning the lender has no other recourse against you for the debt other than taking the property from you, either by foreclosure, short sale or deed-in-lieu. If you took out any other kind of loan, such as a loan on a tri-plex or a refinance of a purchase-money loan, then the lender is able to file for a deficiency judgment against you. These mortgages are known as recourse loans. These distinctions are important not just in determining your personal liability but your tax liability.

Unpaid Debt Tax Exceptions

Unless your debt falls into either an exception to or exemption from the IRS debt rules, you will be taxed on the value of any unpaid debt after a deed-in-lieu, in Arizona or any other state. One key exception to the taxation rule, according to the IRS, is non-recourse loans. Because a non-recourse loan prevents personal liability beyond the property itself, any unpaid debt is not viewed as income. In Arizona, this would mean you would not be subject to taxation for any deficiency between the property value and mortgage balance after a deed in lieu on a one or two-unit building so long as the loan or loans were taken out to purchase the property.

Unpaid Mortgage Debt Exemption

Ordinarily, any unpaid debt that does not fall under one of the IRS exceptions is taxed. However, through 2012, any unpaid mortgage debt up to $1 million for singles and $2 million for married couples arising from foreclosure, short sale or deed-in-lieu on your principal residence is exempt from taxation. For Arizona taxpayers, this would mean even refinanced loans not covered under state deficiency laws would be covered under the federal law.