Short Sale and Foreclosure Tax Ramifications

One of the principal concerns with short sale, foreclosures, or even abandonment of property is the tax consequences. Short sales and foreclosures may have tax ramifications, so it is important to consult your tax attorney or a qualified CPA before you make any decisions.

Will I owe taxes if I do a short sale?

Two tax laws that you should know on avoiding tax consequences of a short sale.

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1) Mortgage Forgiveness Debt Relief Act of 2007

Tax law has been modified in favor of the homeowner when it comes to the short sale of their primary residence. It’s called the Mortgage Forgiveness Debt Relief Act of 2007 (see also IRS link below). With this Act, if you receive a 1099-C from the foreclosing lender (due to the cancellation of debt resulting in the sale of your house), you may not necessarily have to pay taxes on the sale. There are several criteria you have to meet to fall under this Mortgage Forgiveness Debt Relief Act. If you have refinanced and cashed out, the forgiveness only applied only up to the extent of the principal balance of the old mortgage, immediately before the refinancing. So if you pulled out $100,000 then that amount is not included. The “Insolvency Exemption” may cover you for that difference (see below). Mortgage Forgiveness Debt Relief Act recently has been extended an extra year, to now expire January 1, 2013, thanks to a provision in the Emergency Economic Stabilization Act of 2008 (the “Bailout”).

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The Mortgage Forgiveness Debt Relief Act applies towards a foreclosure as well. If the house is foreclosed upon you receive a 1099-A which does not cancel the debt. Form 1099-A reports abandonment of secured property, rather than the cancellation of debt. It reports the balance of unpaid principal debt being paid off- and is compared for tax purposes with the basis of the house to determine a gain or loss. Because lenders independently determine what they believe the house is worth at the time of the foreclosure sale, they may put an artificially low number in there to “get you back”, resulting in a much higher tax hit at tax time. The 1099-A also opens the risk for a lender to pursue a deficiency judgment against you. No worries if it is a non-recourse loan, since the debt is securitized only by the residence. If you have refinanced, then you may be personally liable for that debt, and will receive the 1099-A if it goes to foreclosure.

You will need to use Form 982 at tax time. Let your CPA know that you will need the updated version of this form if they are filing electronically.

Be careful! This exemption does NOT apply towards state law. So even if you are exempt from paying federal taxes, you still may be on the hook at a state tax level. Talk to your CPA.

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2) Insolvency Exclusion Rule

What if I don’t qualify for the Mortgage Forgiveness Debt Relief Act of 2007?

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There is still hope for you. If you read the IRS Form 982, Part I, section 1(b) allows for the ‘discharge of indebtedness to the extent insolvent’. What this means, if that you can prove you are insolvent, then this debt is discharged. You find the definition of ‘Insolvency Exclusion’ and its rules in IRS Publication 908 (see also IRS Publication 908 link below). There are a lot of details associated with this Insolvency Exclusion, so be sure to go over the details with your tax attorney or CPA. Basically, if at the time of your short sale closure your liabilities are greater than your assets, then you can be considered insolvent, no federal taxes will be owed. Sometimes it pays to be poor! The same applies for a foreclosure. If you don’t qualify, then be prepared to pay some taxes.

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Two Strategies to Avoiding or Reducing Tax on Primary Residence or Rentals:

• Make sure your home qualifies as your “primary residence” and then sell it (applicable for federal tax exemption only). If it is not your primary residence, the move into it (residency rules apply [IRS Publication 523].; or
• Check to see if the “Insolvency Exemption” rules apply (applicable to both federal and state laws, in most states). This applies on a short sale or foreclosure.

If Strategies #1 and #2 do not apply how is a short sale, abandonment of the property property, or foreclosure taxed?

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Foreclosure

According to IRS Publication 544 ‘Sales and Other Disposition of Assets’ ‘The foreclosure or repossession is treated as a sale or exchange from which you may realize gain or loss… You figure and report gain or loss from a foreclosure or repossession in the same way as gain or loss from a sale or exchange. The gain or loss is the difference between your adjusted basis in the transferred property and the amount realized.’ IRS Publication 551 defines on how the ‘basis’ is determined. IRS Publication 523 provides details on calculation the basis when you sell your home, as well as other applicable rules and definitions pertaining to the sale of your home.

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Recourse versus Non-Recourse Debt is calculated differently. According to the IRS “If you are personally liable for the debt [(recourse debt), as such is the case for many rentals or many who have refinanced over the years and pulled out cash], the amount realized on the foreclosure does not include the canceled debt that is your income from cancellation of debt. However, if the fair market value of the transferred property is less than the canceled debt, the amount realized includes the canceled debt up to the fair market value of the property. You are treated as receiving ordinary income from the canceled debt for the part of the debt that is more than the fair market value.” Confused? See the IRS Publication 544 for examples.

According to the IRS, income from cancellation of debt is not taxed if any of the following conditions apply:

-The cancellation is intended as a gift

-The debt is qualified farm debt (see chapter 3 of Publication 225).

-The debt is qualified real property business debt (see chapter 5 of Publication 334).

-You are insolvent or bankrupt (see Publication 908)

-The debt is qualified principal residence indebtedness.

So if you are foreclosed upon (or even if you short sell the house), and do not meet any of the above exemptions, then you are liable for the full realized gain or loss, taxed as Ordinary Income (the highest tax level). The Insolvency Exclusion in IRS Publication 908 may apply to you if the house is foreclosed upon. All other exemptions may be difficult to demonstrate with a rental.

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You will owe less taxes if you short sale the house rather than let it foreclose. Call us at 1-(619) 631-4546 to get started – we work in all 50 States!

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So why not just let it foreclose?

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If you cannot qualify for any of the exemptions, then you will take a very large tax hit, since foreclosed properties generally sell for significantly less than short sale properties due to market decline, foreclosure costs, and holding time. If a house is sold as a short sale today for $300,000, in 6 months to a year when the lender finally takes it back, that house (in today’s market) will likely be worth $270,000. That’s a $30,000 difference that will be taxed as ordinary income if it’s recourse debt (slightly different for non-recourse)! As stated previously, you also run the risk of a deficiency judgment against you if you let it foreclose rather than do a short sale. They could attach this debt to another asset (such as your primary residence or other rentals) if they seek a judgment against you. The nightmare would live on…

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Abandonment

The IRS defines abandonment as follows (see IRS Publication 908): ‘The abandonment of property is a disposition of property. You abandon property when you voluntarily and permanently give up possession and use of the property with the intention of ending your ownership but without passing it on to anyone else. Loss from abandonment of business or investment property is deductible as an ordinary loss, even if the property is a capital asset. The loss is the property’s adjusted basis when abandoned. This rule also applies to leasehold improvements the lessor made for the lessee that were abandoned. However, if the property is later foreclosed on or repossessed, gain or loss is figured.

Based upon this definition, the ‘do-nothing’ scenario on a rental that results in the foreclosure would be taxed in the same way as a foreclosure. A 1099-A would ordinarily be issued.

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Short Sale

Whether it is recourse or non-recourse debt, following the completion of a short sale, the lender will issue you a 1099-C for the cancellation of this debt, in most cases. If you are not able to meet the conditions in the Mortgage Forgiveness Debt Relief Act or are not able to prove insolvency, then a short sale will lessen your tax hit, compared to a foreclosure. It’s a double whammy for many, having lost the money invested in the house AND now having to pay federal and state tax on the sale.

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Advantages of a Short Sale over a Foreclosure (from a tax standpoint only)

– credit consequences are entire a different issue, but still equally negative:

Issuance of a 1099-C (cancellation of debt) rather than 1099-A (abandonment of property). No deficiency judgment since a 1099-C satisfies the debt.

• Taxable Income from the Cancellation of Debt on a 1099-C will be less on a short sale compared to a foreclosure. A short sale will procure a higher net value in today’s market due to the absence of foreclosure fees, market decline, and holding costs. Your taxable income from that cancellation of debt will likely be less on a short sale then on a foreclosure.

California Tax Exemptions:  see our blog post at:
http://troubledpropertysolutions.com/1245/california-passes-tax-exemption-bill-when-1099-issued-by-lender/  for a April 8, 2010 update on California mortgage debt foregiveness.

Disclaimer: The information contained within this website is intended for informational purposes only, and is not intended, nor should be construed as professional and/or legal advice. Laws in regards to foreclosure and the individual requirements of trustees and lenders are subject to change without notice, therefore such information should not be relied upon as accurate. You are advised to seek independent legal counsel in regards to any information you may receive from us or any other source in regards to your tax situation.