Tax Consequences of Short Sale

Posted by Help Now on Thursday, September 29th, 2011 at 7:43am.

Considering a Short Sale or Foreclosure

There are two things to consider when deciding whether or not to short-sale or foreclose: Equity and Cash Flow. If you have positive equity in your home you should not Short Sale or Foreclose. If you no longer wish to make your payments you should be able to sell your home without a Short Sale. If you have negative equity (owe more than your home is worth) you need to consider cash flow before making any decisions.

Positive cash flow means the mortgage can be paid each month with your income (not using savings, gifts, or increasing your debt). If you have positive cash flow (break even or better) you should keep your property. Even if it has negative equity. If you can continue to make your payments, do so. If you have negative cash flow (you cannot pay mortgage with your income) and it has negative equity, then it may be time to get rid of the property. More to consider with Short Sales found here.

 
 
Taxes on Forgiven Debt
 
If you have a negative cash flow/negative equity property that you must get rid of, you need to be aware of the possibile consequences. When the property is sold for less than what is owed, the bank loses money. The money lost by the bank is recorded as income for you. This is called cancelation-of-debt income. The debtor (bank) is required to record this cancelation on a 1099-C form. This income is taxable. You may receive the 1099-C immediately, or as much as 1-2 years after the debt is forgiven.

When you receive a 1099-C, you may find yourself upset at the prospect of being taxed on this 'income'. If you find yourself thinking this way, just remember how much better it is than having to pay off the entire debt.

Disputing Your 'Income'

The amount on the 1099-C is something that you can dispute. If the amount looks high you should check to see what the bank sold the home for. If the bank sold the home below market value it will increase their loss and increase your taxable 'income'. Contact a real estate professional to analyze what the home was sold for to ensure that the amount reflects true market value.

Getting out of Paying Taxes

There are a few ways you can get out of paying taxes on your forgiven debt. The Mortgage Forgiveness Debt Relief Act protects those losing their primary residence.

If the property involved in the Short Sale or Foreclosure was your primary residence then you do not have to pay tax on the forgiven debt. The Mortgage Foregiveness Act covers debt forgiven up to $2 million. However, the benefits of this act are only good through the end of 2012.

IF you have a 2nd mortgage or re-finance debt on the property it will NOT be covered by the Debt Foregiveness act. Unless you can prove that the 2nd mortgage or re-finance funds were used exclusively to improve the primary residence. Then it falls under the Mortgage Foregiveness Act and is not taxable income.

Is It Your Primary Residency?

How can you be sure your home is your primary residence? Some people own more than one home. In this situation your primary residence is the home you live in the most. You can only have 1 primary residence. There are severe consequences if they discover it was not your primary residence, but you claimed that it was.

Other things to help you determine primary residence: which address are you registered to vote at? Where is your car registered? What address is on your drivers license? Bank statements? Etc.

If the property is NOT your primary residence

Things get very tricky here. Always consult a CPA or an attorney if pursuing one of the following approaches.

If you have a rental property: there are 4 possible ways to deal with the taxes from debt forgiveness: (1) pay it, (2) run the numbers, (3) prove insolvency, and (4) defer payment. The first option is obvious, just pay the taxes. As we discussed earlier this is a lot better then paying off the entire debt. The other options are more complicated.

Running the Numbers: What is your actual income

Even though you have debt forgiveness income, you also have to take into account your losses. The largest of these being your house. The loss on the sale of the property may offset the income from the debt forgiveness. This is NOT the kind of assessment you can do with Turbo Tax. You need an experienced accountant (preferably one who has done it before) to help you run these numbers.

Insolvency – Bankruptcy Exception

If you can prove that you are insolvent you don't have to pay taxes on the 1099-C income. If your assets are worth less than your liabilities you are considered insolvent. This is proven by adding up all your assets (not including retirement plans) then subtract all your debts and mortgages. If you have a negative net worth you are insolvent. To prove insolvency there is another form you must complete (982). Record the assets and liabilities as they were at the date when the property was lost (not the date you're filing your taxes).

Insolvency Worksheet here

Defer Payent

This isn't really a way to get out of paying the taxes, but a way of delaying the pain. This process of deferred payment requires a basis adjustment strategy (form 982). This strategy will take the gain from the forgiven debt (1099-C) and spread it out over your other properties. This only delays the pain of paying the taxes on the full debt forgiven, but may help until you can get back on your feet.

More in-debth information available here: IRS publication 4681

About the Author:

Utah Dave - Neighborhood ExpertUtah Dave - Daybreak Neighboorhood Expert and Local Resident

My friends nicknamed me Utah Dave in high school because they said it didn't matter where we went in Utah, I would know how to get there and who we needed to talk to. The name sticks today as UtahDave has formed into a professional real estate network of Neighborhood Experts all across the state. I live in Daybreak with my wife and 4 amazing children. I enjoy dancing (which is how I met my wife Dawn) as well as traveling, coaching, and learning.

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