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08/24/09: Tax Treatment On Foreclosures And Short Sales

HOUSING COUNSEL

By: Benny L. Kass

Q: I am in the process of selling my house as a short sale. My mortgage is $450,000. The current value of my house is $375,000, and my lender has agreed to allow me to sell it for that price. Under the terms of the sale, my broker will get a three percent commission and after all closing costs are paid, the lender will get all of the net sales proceeds – $360,000. I have been advised that I will have to pay some kind of income tax on the amount of money that the lender will not get. Please advise.

A: If this is your principal residence – the home in which you live most of the year, vote and pay taxes on – and if the money you borrowed was used to buy, build or substantially improve that home, you will not have to pay any income tax on the debt that was forgiven by your lender.

This is a departure from the general rule which requires debtors to report all forgiving debt as ordinary income.(§ 61(a)(12) of the Internal Revenue Code). Up until the so-called “mortgage meltdown” occurred, there were two exceptions to this rule that impacted residential homeowners. If your debt was discharged by a Bankruptcy Court, or if you are insolvent, you were not obligated to pay any tax in this cancelled debt.  The IRS defines “insolvency” this way: “the total of all your liabilities exceeded the FMV (fair market value) of all of your assets immediately before the cancellation.”

However, when thousands of homes across the country began to be foreclosed upon, Congress amended the law. For debts forgiven in calendar years 2007 through 2012, up to $2 million of forgiven debt can be excluded from the obligation to pay income tax ($1 million if married filing separately). And according to Julian Block, a prominent tax attorney, even if you are a single taxpayer, you still can exclude the full $2 million. Furthermore, the exclusion applies to all years, and not just for one.

This is an interesting loophole in the law. If you own more than one home that is “under water” – i.e. the mortgage exceeds the FMV of the house – you can only claim the exclusion for your principal house. If that house is foreclosed upon (or sold via a short sale), nothing prohibits you from moving into your second home, establishing it as your new principal residence, and so long as your total losses do not exceed the statutory cap of $2 million, you can also sell that house at a short sale (or let it go to foreclosure) and not be required to pay any income tax.

Of course, when dealing with the IRS, nothing is easy. The law does not apply to all forgiven or cancelled debt. So your vacation home, your car loan or your credit card debt that is cancelled will not qualify for the exclusion, unless you are insolvent or file for bankruptcy relief.

As mentioned earlier, the debt has to be used to buy, build, or substantially improve your home. This is called the “Qualified principal residence indebtedness” (QPRI). According to the IRS, “debt used to refinance qualifying debt is also eligible for the exclusion, but only up to the amount of the old mortgage principal, just before the refinancing.”

Let’s use this example:

Becky purchased her home in 2002 for $315,000 and obtained a $300,000 mortgage. A year later she got a second mortgage in the amount of $50,000, which moneys were used to add a garage to her house. In 2008, when the outstanding balance of those two loans was down to $325,000, Becky obtained a new loan of $400,000. For tax purposes, her QPRI was $325,000. She used the additional $75,000 ($400,000 - $325,000) to pay off personal credit cards and to pay her daughter’s college tuition.

She sold her house under a short sale for $300,000. The new lender forgave $100,000. However, under the new law, she can only exclude $25,000 ($100,000 cancelled debt minus the $75,000 that was not QPRI). To add insult to injury, unless Becky files for bankruptcy relief or can claim insolvency, she will have to pay ordinary income tax on the $75,000 that cannot be excluded.

Had Becky used the refinance proceeds to substantially improve her home, she would have been able to exclude more of the cancelled debt.

How is this handled when filing your next income tax return? First, if your debt is reduced or eliminated, your lender must send you Form 1099C, (cancellation of debt). By law, this form must show the amount of debt forgiven and the fair market value of any property given up through foreclosure or a short sale. If you are in this situation, make sure that the information provided on the form is accurate; keep in mind that the IRS will get a copy of this form also.

If you qualify for the exclusion, you must complete Form 982 (Reduction of Tax Attributes Due to Discharge of Indebtedness) and attach it to your federal income tax return. If you do not qualify, the cancelled debt shown on the lender’s form is treated as ordinary income, for which you will have to pay the appropriate tax.

This is extremely complicated, and especially hard on consumers who have lost their family home. For more information, the IRS has issued Publication 4681, entitled “Cancelled Debts, Foreclosures, Repossessions and Abandonments”, which you can obtain on line (www.irs.gov/publications). Additionally, Julian Block has written “The Home Seller’s Guide to Tax Savings”, which can be purchased on his website: www.julianblocktaxexpert.com.

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