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07 June 2012
I have been thinking about short sales lately, mostly because many think we will see an increase in these types of transactions in the months to come. These are tough transactions not only because a borrower has lost their house, but because there is potentially a double whammy on the closed side of a short sale.
By definition the short sale seller’s lender (or lenders) is accepting less than is owed to release its lien upon or against the property. I am concerned here with what is still owed after closing. Consider this example:
Suppose that the seller owes $300,000.00 on a purchase money mortgage and the proceeds of a short sale only produce $275,000.00. That leaves a balance of $25,000.00 that the seller still owes. What does the lender do about this $25,000.00?
If the borrower has personal liability for this $$$$, as they would on a purchase money loan, then the lender could attempt to collect this money by all available means, including a debt action in the appropriate court. But if the lender decides not to pursue collections, this may well constitute forgiveness of the debt. Forgiveness of debt equals ordinary income for the I.R.S. Further, forgiveness may well result in the short seller receiving a 1099-C which, again, is taxable income.
So here’s where we are so far:
- The seller is “out from under” a house with more debt than value
- The seller still has liability for $25,000.00
- The seller may have ordinary income to the extent of $25,000.00 if the lender does not attempt to collect – this means tax liability.
With respect to the tax liability, Congress, in an effort to increase short sales and reduce the number of more harmful foreclosures, gave home owners some relief. (Please refer to the Mortgage Debt Relief Act of 2007 and to I.R.S. Publication 4681. Further, note that this legislation is currently set to expire at the end of this year but Congress is, supposedly anyway, working on an extension.)
So ok, how does this tax relief work and who can take it? First, short sale sellers can, without tax liability, have $2,000,000.00 or less of debt forgiveness on their principal residence only, i.e., where they reside. Further, the loan in question must have been for purchase money or improvements. If these criteria are met, then tax relief is available.
So, what if the short sale sellers are not able to rely on the Mortgage Debt Relief Act? There are still a couple of ways to avoid the tax liability and they both deal with insolvency, you owe more than you have asset value (really non-exempt asset value). Insolvency, in the context of a short sale, may be established by bankruptcy or certification by a C.P.A. Note that the amount of forgiven debt for which tax relief will be available equals the “amount” of insolvency. So if you owe $40,000.00 more than you own, then $40,000.00 of a cancelled debt may be excluded from your income for tax purposes.
This is a complicated area of law and my examples and musings here are provided by way of illustration. Each transaction is different and each short sale seller presents a different tax picture.