You’ve just spent several l weeks to negotiate a short sale. You’ve demonstrated to the lender that the home’s price has fallen and that to close the deal with the new buyer, the lender will have to forgive $9,000 of the outstanding mortgage loan not covered by the sale proceeds. Now everyone is happy. The buyer gets a home, the lender avoids a messy foreclosure, and the you walk away with no further financial burdens. Well, not quite.
Whenever real estate is sold, whether in a standard transaction, a short sale or a foreclosure auction, there are potential tax consequences for the seller. In this little scenario, the seller may still owe taxes to Uncle Sam — both in the form of capital gains on the home and on the unpaid portion of the mortgage. Yet, too often, real estate practitioners are unaware of the tax liabilities arising from the cancellation of debt and fail to advise their clients accordingly.
With a short sale, the lender has three possible ways to handle the deficiency balance, which is the portion of the mortgage debt not covered by the sale of the home. First, the lender can attempt to collect the deficiency balance from the sellerafter the property has closed. Second, the lender may require the seller to sign an unsecured promissory note for the deficiency balanceas a condition of agreeing to the short sale. If the new note is for less than the balance of the original debt, the difference would be considered canceled, or forgiven, debt. Third, the lender may agree to cancel the entire deficiency balance.
On the surface, option three would be seem to be the best alternative for a seller. However, the IRS considers any canceled mortgage debt ordinary income. This means that the amount forgiven is taxed at the same rate — somewhere between 15 percent and 30 percent — as the sellers’ salaries. In addition, because the IRS requires the lender to file a 1099-C form stating the amount of the canceled debt, Uncle Sam will have a record of the exact amount of the debt that was cancelled. A seller will also receive a copy of the 1099-C to use in filing income taxes. The seller’s home state would also consider the cancelled debt as ordinary income.
The IRS does recognize four situations in which cancellation of debt will not result in tax liability for the seller. A seller may avoid tax liability:
When the borrower receives a bankruptcy discharge and the deficiency was included in the bankruptcy
When the borrower is insolvent at the time of the cancellation of the debt. Insolvency would occur when a borrower’s liabilities exceed assets. Note that seller would have to prove this insolvency to the IRS when filing a tax return.
When the debt was secured by a nonrecourse loan. Under a nonrecourse loan, the lender does not have the legal right to collect a deficiency judgment from any assets of the debtor not pledged to secure the loan. While most home mortgages are do not fall into this category, purchase money loans on a person’s residence are nonrecourse in some states.
When the tax liability from the cancellation of debt on an investment property can be offset against other business liabilities and expenses. This exception does not apply to properties occupied as a residence by the mortgagor.
In many short sales, a seller would be able to qualify under the first two of these exemptions, especially since it was almost certainly necessary to show financial hardship in order to convince the lender to agree to a short sale. However, it is the seller’s responsibility to notify the IRS why the amount in the 1099-C should not be counted as ordinary income. Otherwise, the IRS will consider the forgiven debt as income and penalize the seller for unpaid taxes.
To ensure that you don’t run afoul of the IRS , you should seek professional tax advice regarding the possible tax consequences of selling the home. We can help.
This article is for informational purposes only. This is not to provide legal or tax advise. Seek an attorney or CPA for expert advise. We can provide you with a list of expert advisors we refer our customers to.
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