Possible Tax Ramifications of a Short-Sale or Foreclosure
** We are not tax experts. The information and examples provided below are for informational purposes ONLY. It will serve in a starting point to further investigate how a short sale or foreclosure may effect your taxes. We HIGHLY RECOMMEND that you consult a CPA and tax advisor regarding your tax obligations BEFORE you consider a short sale, deed-in-lieu-of-foreclosure or foreclosure. **
Just Passed! H.R. 3648 - Mortgage Forgiveness Debt Relief Act of 2007
10/4/2007 - The Mortgage Forgiveness Debt Relief Act of 2007 was passed by Congress – This bill amends the Internal Revenue Code to exclude from gross income amounts attributable to a discharge of indebtedness incurred on a principal residence.
H.R. 3648 would ensure that any amount forgiven on mortgage debt secured by a principal residence will not be taxed.
This bill will apply wheter it is a short sale, foreclosure, deed in lieu of foreclosure or any other similar arrangment that relieves the borrower of the obligation to pay some portion of their debt on their primary residence.
** Again, We HIGHLY RECOMMEND that you consult a CPA and tax advisor regarding your tax obligations BEFORE you consider a short sale, deed-in-lieu-of-foreclosure or foreclosure. **
Many homeowners do not realize that they may be in store for a tax bill (1099-C or 1099-A) from the IRS after the short sale, foreclosure or deed in lieu of foreclosure of their home. Every situation is different and you should ABSOLUTELY contact an accountant or tax advisor before conducting a short sale, deed-in-lieu-of-foreclosure or foreclosure to determine your potential liability.
Example 1: Assume you purchased your home for $500,000. When you purchased the home, you took a first and second for a total of $450,000. Circumstances in your life put you in a position that you are no longer able to make the payments and now need to sell your home. Due to the decline in the market, you are only about to sell for $400,000. Your lender agrees to the transaction, taking less than is owed and forgiving you of the $50,000 loss.
Enter the IRS. When the mortgage company forgives the difference, the IRS considers the $50,000 that was "forgiven" by the lender as "debt relief" income. Your lender will probably send you a 1099-C in the amount of $50,000 and the IRS will want you to pay taxes at the rates for ordinary income, same as for salary.
Example 2: Assume you purchase a home for $500,000 and uses it as a personal residence. When you purchased the home, you took a first and second for a total of $450,000. Circumstances in your life put you in a position that you are no longer able to make the payments causing you to default and the lender forecloses on the property. Similar homes at the time sell for $4000,000.
Enter the IRS. When the mortgaged property is foreclosed or repossessed, and the bank re-acquires it, or the bank the owner has abandoned the property. The bank usually sends a Form 1099-A to the owner and the IRS. Using the numbers in the example, the 1099-A indicates the foreclosure bid price ($4000,000), the amount of your debt ($450,000), and whether you were personally liable. Debt cancellation (here, $50,000) is taxed at the rates for ordinary income, same as for salary.
These are both simplistic examples and most cases are more complex, but the bottom line is that you need to be aware of the potential tax liabilities involved in a short sale, deed-in-lieu-of-foreclosure or foreclosure.
What are the odds that you have that kind of money laying around after you just went through a short sale on your home? Be very careful regarding your tax obligations BEFORE you consider a short sale, deed-in-lieu-of-foreclosure or foreclosure.
The IRS will use your tax basis on your property to determine your tax obligations so you must be able to figure this amount out.
Read the article below on IRS Form 982. The form is used to request a "reduction in tax attributes" due to insolvency. This may allow you to avoid having to pay taxes on the debt relief you experience with a short sale. Definitely worth talking to a tax attorney or accountant about!
IRS Form 982 - Avoid Debt-Relief Taxes
Is there a way to avoid paying that tax? Possibly…IRS form 982 says, “Generally, the amount by which you benefit from the discharge of indebtedness is included in your gross income. However, under certain circumstances described in section 108, you may exclude the amount of discharged indebtedness from your gross income”. The specific instructions are contained in section 108 of the Internal Revenue Code.
One of the “circumstances” they are referring to is that if you are insolvent before you conduct a short sale then you may be able to “exclude” the forgiven indebtedness (the amount the lender forgave on the loan) from being added to your gross income for that year. Here are some questions you will need to ask an expert:
- Can I avoid paying taxes on the forgiven debt if I was insolvent at the time of the short sale?
- Do I have to file bankruptcy to be considered insolvent?
- If you already used a short sale and paid taxes can you file an amended return and get a refund?
- Does your real estate agent understand any of this?
- Do you have to surrender your property in bankruptcy to be eligible for relief?
- Does a form 982 have to be filed in order to be eligible for tax relief?
These are just a few of the questions that should be asked. But, it may very well be worth it. You can find Form 982 here.
Insolvency – The inability to pay one’s debts as they come due. Even though the total assets of an individual may exceed their total liabilities, they are insolvent if the assts cannot be converted into cash to meet the current obligations.
Form 982 from the IRS is available here.
Publication 523 from the IRS is available here.
** Please remember, we are not tax experts. The information and examples provided above are for informational purposes ONLY. It will serve in a starting point to further investigate how a short sale or foreclosure may affect your tax obligations. We HIGHLY RECOMMEND that you consult a CPA and tax advisor regarding your tax obligations BEFORE you consider a short sale, deed-in-lieu-of-foreclosure or foreclosure.