Short Sale Tax: What you need to know

As  long time California Realtors  who have done quite a few successful short sales over the current Real Estate market downturn as well as the last downturn over a decade ago, one of the things I like to make sure of when I meet a potential client that is looking to do a short sale is to give them a thorough  understanding of how short sales work.

Real Estate short sales can be very complicated transactions. Anyone who actively and regularly participates in short sales knows that almost every single transaction is invariably different.  Each lender has their own set of rules as well as their process on how they go about the short sale process.

Short sale tax is one of the areas in particular that I feel is extremely important to educate a seller on when he or she is considering doing  a short sale.  Different rules apply for short sales of primary residences and investment properties.

If you are  short selling your primary residence,  The Mortgage Debt Relief Act of 2007 generally allows taxpayers to exclude income from the discharge of the debt. The debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a short sale or foreclosure, qualifies for the relief granted under The Act.

The Mortgage Debt Relief Act applies to debt forgiven during calendar years 2007 through the end of 2012. Up to $2 million of forgiven debt is eligible for this exclusion or $1 million if married filing separately.  The exclusion does not apply if the discharge is due to services performed for the lender or any other reason not directly related to a decline in the home’s value or the taxpayer’s financial condition. This act was put in place for the specific purpose of helping home owners avoid the financial hardship caused by doing a short sale on their primary residence.

Prior to this relief act being put in place the IRS would treat the forgiveness of a debt as a taxable event. The logic behind it is; when you take out a mortgage there as an assumed obligation that you will be paying it back. When money is borrowed, the borrower is not required to include the loan proceeds as income because the borrower has to pay back the loan. When the obligation to pay back the loan is removed, the amount of the proceeds the borrower  received then becomes reportable as income because there is no longer an obligation to repay. Hence the term “relief of debt”.

When there is a cancellation of debt, the lending institution cancelling the debt is usually required to report said amount of canceled debt to you and the IRS on  Form 1099-C, Cancellation of Debt. Eligible home owners must complete IRS form 982 which must be included with the Federal tax return to claim relief under the Mortgage Debt Relief Act.

For those of you who are selling a property which is not your principle residence, you will likely be paying taxes on any short sale deficiency that is forgiven!

This is obviously a significant consideration when determining whether doing a short sale is the right move for you or not.  Debts forgiven that do not fall under the debt relief act include rental properties, business properties, 2nd homes and car loans. Credit cards also do not apply unless you were insolvent just prior to the cancellation of debt.

According to the IRS website, the most common situations when the cancellation of debt income is NOT taxable are:

§  Qualified principal residence indebtedness: This is the exception created by The Mortgage Debt Relief Act of 2007 and applies to most homeowners short selling a primary dwelling.

§  Bankruptcy: Debts discharged through bankruptcy are not considered taxable income.

§  Insolvency: If you are insolvent when the debt is cancelled, some or all of the cancelled debt may not be taxable to you. You are insolvent when your total liabilities exceed the fair market value of your total assets.

§  Certain farm debts: If you incurred the debt for the purpose of running a farm, more than half your income from the prior three years was from farming, and the loan was owed to a person or agency regularly engaged in lending, your cancelled debt is generally not considered taxable income.

§  Non-recourse loans: A non-recourse loan is a loan for which the lender’s only remedy in case of default is to repossess the property being financed or used as collateral. In other words the lender is not allowed to pursue you personally in case of a default. Forgiveness of a non-recourse loan resulting from a foreclosure does not result in cancellation of debt income. However, it may result in other tax consequences.

Whenever you are dealing with a short sale and there are possible tax consequences, it is  always recommended that you speak with  a qualified tax professional or attorney who is well versed in these matters.

One additional consideration I would make sure to not overlook is  your potential liability to the California  Franchise Tax board.  There are a lot of Realtors who are doing short sales and are not fully aware about the potentially deleterious impact of debt relief. A single error in this area can cause home sellers tens of thousands of dollars… don’t let that happen to you. Though we are not tax experts or attorneys and this information is not to be construed as tax or legal advise, we are able to properly represent you with the Real Estate aspect of short selling your home. We also have the resources to help you find a qualified tax or legal professional who can answer questions related to law or income tax. Feel free to contact us any time, we would be glad to help.