HOW WILL A SHORT SALE AFFECT YOUR TAXES
If you owe a debt to someone else and they cancel or forgive that debt, the canceled amount may be taxable. However, if a short sale settlement is reached and the borrower is an owner-occupant in a homesteaded property, he may not have to pay taxes on the forgiven debt. Homeowners whose mortgage debt was partly or entirely forgiven between 2007 and 2012 may be able to claim special tax relief by filling out newly-revised Form 982 and attaching it to their federal income tax return, according to the Internal Revenue Service. The new Mortgage Debt Forgiveness Relief Act was signed into law by President Bush on December 20, 2007. This law can eliminate taxes that would often be due from the homeowner in the event of a short sale.
The Mortgage Debt Relief Act of 2007 generally allows homeowners to exclude income from the discharge of debt on their principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure or short sale qualifies for the relief.
This provision applies to debt forgiven in calendar years 2007 through 2013. Up to $2 million of forgiven debt is eligible for this exclusion ($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.
WHAT INVESTOR / OWNERS FACING A FORECLOSURE
NEED TO KNOW WHEN CONSIDERING A SHORT SALE!
It is commonly believed by many Investors that they want the highest offer possible in a short sale that would yield the lowest possible deficiency and therefore less tax liability when the bank sends them a 1099C for the forgiven debt. Unless you qualify for an “Exclusion” the IRS may treat the forgiven debt as a taxable income. Depending on your specific financial situation, this assumption could be dead wrong and may end up costing you thousands of dollars in taxes you didn’t need to pay.
First it is important that you understand the difference between Recourse Debt and Non-Recourse Debt. You should consult your attorney or tax adviser to be certain whether you have a Recourse Loan or a Non-Recourse loan.
In the event of a recourse debt your lender may have the option to pursue a Deficiency Judgment for the balance owed but many lenders choose not to sue because defaulting borrowers often don’t have much to sue for. Should your lender choose to forgo the expense of pursuing a deficiency judgment they will most likely discharge the debt and issue you a1099C. Prior to the Mortgage Debt Forgiveness Relief Act the IRS treated the forgiven debt as a capital gain and taxable income.
There are several ways for a seller involved in a short sale to be excluded from paying taxes on the forgiven debt.
“Mortgage Debt Relief Act” if it is their primary residence.
A Title 11 Bankruptcy
- Qualified Business Indebtness
Should the Investor / Owner seek the HIGHEST offer in a Short Sale?
The IRS defines Insolvency as the total FMV of all Personal Assets less your total Liabilities (Debt prior to forgiveness). What this means is that the higher a deficiency is after the short sale the more debt or liability you have to offset your personal assets making it easier to claim exclusion under insolvency.
This may seem counter intuitive to most investor / homeowners as many believe that they should sell the property for the highest possible offer in order to have the least amount of deficiency. However if you believe that you may be borderline for claiming exclusions under the insolvency rule that assumption could be completely wrong. In order to claim exclusion under the “Insolvency Rule” you want the highest possible deficiency to offset your personal assets. Therefore you actually want to sell the property for the lowest possible price in order to create the highest possible deficiency!
What if you used a Business to Purchase the Investment Property?
You may still be in luck. Page 7 of IRS Publication 4681 states the following. “You can elect to exclude canceled qualified real property business indebtness from income if the debt was incurred or assumed in connection with real property used in a trade or business.”
The following was taken directly from the Mortgage Debt Forgiveness Act and relates directly to Investor owners considering a Short Sale of one or more properties that were purchased in their personal names.
Question: If part of the forgiven debt doesn’t qualify for exclusion from income under this provision, is it possible that it may qualify for exclusion under a different provision?
Answer: Yes. The forgiven debt may qualify under the insolvency exclusion. Normally, you are not required to include forgiven debts in income to the extent that you are insolvent. You are insolvent when your total liabilities exceeds your total assets.
If you believe that you may qualify for an insolvency exception, see Page 4 of IRS Publication 4681 and the instructions for Form 982 (Reduction of Tax Attributes Due to Discharge of Indebtness) which discusses each of these exceptions and includes examples.
What Should You Do?
Finding competent legal advice is without a doubt easier said than done! I know, I tried!
Apparently, not ALL Tax Advisors are created Equal!
Now that you know what to look for and what questions to ask, finding a tax advisor who is familiar with IRS Publication 4681 and Form 982 is not as easy as it sounds. I personally set out on a mission to prescreen and interview several tax advisors in order to find someone that was qualified to speak to my clients. Someone who could not only give good advice but be there when tax time comes to properly complete all of the forms.
I sent probably close to 40 emails to CPA’s and Tax Attorney’s and not a single one was answered. Frustrated, I started making phone calls. It took me almost three days calling every tax advisor in town before I found someone who could actually give me some straight answers.
We strongly suggest that you schedule a consultation with an expert in Tax Law before you consider a Short Sale to make certain you understand exactly what type of strategy you need for your personal situation. We also recommend that you read the publications mentioned above and complete the worksheets so that when you meet with an expert he has the information he needs to properly advise you.
Give us a call and we’ll help you get started and answer any questions you may have!
President and Acquisitions Manager