IRS Tax Implications from a Short Sale

The information below aims to provide a general understanding on the most recent changes in the IRS tax structure as its affects property short sales.

In order to avoid home foreclosures, which can be costly and lengthy, banks often engage in negotiations with borrowers who choose to take on the task of selling their home as opposed to walking away from the home and allowing the bank to foreclose. The resulting transaction is known as a real estate short sale since the homeowner's mortgage lender agrees to alter the original terms of the loan by lowering the outstanding balance of the debt in order to accommodate the sale of the property. Thus, under a short sale the home owner is allowed to sell their home for less than their outstanding debt and give the proceeds to the lender in return for forgiveness of the loan.

Such sales transactions might help a homeowner avoid foreclosure, but they may also result in a number of tax implications to the seller. Where the parties are able to reach a short sale agreement the forgiven portion of the loan may still be taxed as income on the part of the borrower. Most likely the seller's lender will issue them a form 1099C Cancellation of Debt after the close of the trasnaction.

For instance, let’s say that there is a loan on a house for $250,000 and in today’s declining housing market the home is sold for $175,000. After factoring in closing fees, the seller's bank might only net a total of $155,000. The bank has then forgiven the seller for a total debt of $95,000 ($250,000 mortgage balance less $155,000 netted from short sale of house). The bank will then most likely issue the seller a form 1099C at the end of the year in the amount of $95,000, which means the seller will have to report this amount as earned income on top of all their ordinary income for the year when they file their income tax returns.

The issue is that a lot of homeowners facing foreclosure today may not be aware of such a tax liability. Now we're not tax professionals, but in general terms on the scenario above, it would not be suprising to find out from a CPA that the taxes resulting from this short sale could wind up in the neighborhood of $15,000 - $20,000. This is why it is so important for any homeowner that may be contemplating such a sale to seek appropriate help from tax professionals.  

Mortgage Debt Relief Act of 2007

Well, here’s the good news, for those that qualify anyways. If the seller has lived in the home (in other words, it was not an investment property), they may be able to get tax relief from the IRS when faced with a 1099C on a forgiven mortgage debt. Certain criteria must be met, but the relief is available.

In general, the IRS tax code specifies that a borrower must file a 1099C Cancellation of Debt form when the tax payer has received debt forgiveness. Traditionally, the IRS has treated this amount as fully taxable income on the part of the borrower. But the 2007 Mortgage Forgiveness Debt Relief Act, amended the tax laws to allow borrowers negotiating the loan on their primary residence to avoid having to declare this debt as income (limited to debts of $2 million or less). Please note, the debt forgiveness stipulation described above does not apply to rental properties or other non-primary residences that a lender may hold. And there are additional stipulations regarding refinanced loans versus purchase money loans.

Previously, only a personal bankruptcy filing could prevent the forgiven debt from being treated as taxable income. In cases where the borrower declares bankruptcy, the debts are fully discharged although the declaration may have broader adverse effects in terms of other financial and tax obligations. And under certain circumstances the debt is not taxable if a professional accountant has determined that the value of the debt is greater than the appraised, fair market value of the asset in question.

If you are seeking to execute a short sale on a residence other than your primary home, but which served as a secondary residence for you personally during the last five years, the Relief Act also provides a graduated scale of gross income reductions. Depending on the time you physically lived in the home in question, you may be able to deduct a portion of the forgiven amount.

And one last consideration is the possibility of facing capital gains taxes as a result of selling the home. It is possible for a homeowner to be underwater in their mortgage and still find themselves liable for capital gains taxes. This of course depends on the original purchase price of the home and several other factors such as length of time the home has been owned, the frequency of refinances and possible proceeds or cashed-out equity from the propoerty.

What does this all mean?

It's always best to seek the advice of a qualified tax professional regarding the possible taxable events that could result from such a short sales transaction.

* Disclaimer: As licensed Real Estate Agents, we are not an accountants or attorneys, and we cannot give such tax or legal advice. The information shown above is purely for informational puropses only and should not be relied upon for your own unique situation. It is important to consult with a professional tax professional and/or seek legal advice from an attorney when considering the implications of the law upon your individual situation.