Short Sales and Tax Consequences

Many homeowners facing foreclosure opt to go the short sale route. In a nutshell, a short sale is an agreement between the homeowner and his mortgage company whereby the mortgage company agrees to accept less than what is actually owed on the mortgage as a full payoff of the loan.

Tax Consequences: Foreclosure Debt as Taxable Income

As simple as this may sound, a short sale negotiation can be very time consuming and any homeowner considering a short sale is advised to consider the tax implications with a short sale before finalizing the deal. Prior to enactment of the Mortgage Forgiveness Debt Relief Act of 2007, any debt forgiven by a lender was treated as taxable income to the borrower. For example, if a homeowner owed $100,000 on his mortgage and sold the property in a short sale for $75,000, if the lender forgave the $25,000 short fall, the debtor was required by law to claim the $25,000 of canceled debt as income for tax purposes. The rationale behind this is that a borrower who is relieved from the obligation to repay a debt has, in essence, received income. The IRS taxes such income to prevent borrowers from receiving a windfall. For a homeowner struggling to make ends meet, the prospect of creating a debt to the IRS made a short sale much less inviting.

Mortgage Foregiveness Debt Relief Act

However, enactment of the Mortgage Forgiveness Debt Relief Act relieved certain homeowners of the tax consequences associated with a short sale. Under the Act, a homeowner whose primary residence is foreclosed on or who sells his primary residence as a short sale no longer has to claim the lender's loss (the amount of the debt that was forgiven) as income on his tax return. According to the IRS website, “debt reduced through restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief,”as long as the home was the borrower's primary residence. Up to $2 million of forgiven debt qualifies for the exclusion. However, the maximum exclusion for married taxpayers filing separately is $1 million.

What Doesn't Qualify for Debt Relief?

Keep in mind that debt forgiven on second homes, vacation homes, and rental properties does not qualify for the exclusion. Additionally, canceled debt on credit cards and auto loans does not qualify. Moreover, the Mortgage Forgiveness Debt Relief Act only applies to forgiven or canceled debt used to buy, build, or substantially improve a primary residence. It also applies to refinance debt to the extent that the principal balance of the original loan, immediately prior to the refinance, would have qualified. The Act applies to qualified principal residence indebtedness forgiven between January 1, 2007 and December 31, 2012.

Debt Excluded from Taxable Income

There are several instances when the IRS does not require cancelled debt to be treated as income:

1. Debts discharged in bankruptcy are not treated as taxable income.
2. If at the time the debt is canceled the taxpayer is insolvent, he is not required to report the forgiven debt as income. A person is considered insolvent if his total debt exceeds the fair market value of all his assets.
3. The third exception to the rule that canceled debt is taxable involves certain farm debts. If the debt was incurred directly as a result of operation of a farm, the taxpayer derived more than half his income from the three prior years from farming, and the loan is owed to a person or entity that is regularly engaged in the business of lending money, canceled debt is generally not considered taxable income.
4. Non-recourse debt which is forgiven is not treated as taxable income.

• If you are in the process of Foreclosure or may be facing Foreclosing soon and need professional legal assistance, Submit your Case for a Free Review from a Foreclosure Attorney in your area to be aware of your options.

Content Related to Topic

• How A Short Sale Works
  The process and rules of Short Sales.
• Short Sales and Defiency Judgments
  The legal effects of Defiency Judgments in the process of Short Sales
• Short Sale Risks
  There are quite a few risks in Short Sales to be aware of.

[1] A non-recourse loan is a loan for which the lender's only remedy in the event of a default by the borrower is to repossess the property which is the collateral for the loan. In other words, the borrower has no personal liability for the debt and the lender cannot pursue collection efforts against the debtor beyond repossession of the collateral for the loan.