Taxing Short Sales and Foreclosures

It is surprising to many that one can loose a home by selling it as a short sale or letting the bank foreclose on it and still be liable for payment of income tax on the amount the lender lost during the transaction (Read the: “Homeowner’s Guide: Short Sales and Preventing Foreclosure“)

Two types of income can result from a foreclosure or short sale: capital gains/loss, and relief of indebtedness income.

[UPDATE: Dec 20, 2007 Tax relief for short sales & foreclosures signed (Mortgage Forgiveness Debt Relief Act of 2007 H.R. 3648)]

Disclaimer: If you require specific legal or tax advice, you should contact an attorney or a professional CPA. This information is intended to provide general information and it is not substitute for individual legal and tax advice.

Federal Income tax results in a foreclosure

A completed foreclosure transaction is treated the same as a regular sale for income tax purposes on the year the foreclosure is finalized. So, just like with any other sale, a foreclosure can result in either gain or loss. In addition to capital gain or loss, you can also be taxed on the “debt relief” income.

Federal Income tax results in a short sale

A completed short sale transaction can result in both capital gains/loss and debt relief income. These are calculated separately. If the lender accepts less than what you owe on the full balance due in order to mark the loan paid in full, this difference will become “debt relief income” and it is taxed as “ordinary income” (See 26 U.S.C. § 61 and §§ 1001 through 1016)

Capital Assets and ordinary assets

If a property is purchased and held for resale or inventory (example: lots or subdivisions held by the developer), these assets are considered inventory or ordinary (non-capital) assets. Therefore, a gain or loss on the sale of theses assets is taxed as ordinary gain or loss.

If a property is purchased and held for any other purpose (example: personal residence or an office building used in a trade or business), these assets are generally considered “capital assets”. Whether there is a gain or a loss on the sale, these capital assets are taxed as capital gains or capital losses. (See 26 U.S.C. §§ 1221 and 1231.)

Debt relief income

Also known as “discharge of indebtedness income” or “relief from indebtedness income” or “cancellation of debt income” or “COD income” generally speaking is the amount of debt that is forgiven or discharged by the lender. This income is applied in a short sale, foreclosure or deed-in-lieu of foreclosure transaction.

Debt relief on recourse loans

The “debt relief” rules will apply if you are personally liable for the debt (recourse debt). You may have to pay ordinary income taxes on the amount of “debt relief income”. This tax is in addition to any “capital gain” income tax you may owe.

Debt relief on non-recourse loans

Per California anti-deficiency provisions (CCP 580b & 580.7), if you are not personally liable for the debt (non-recourse debt), meaning the lender’s only security is the property itself, not your personal assets, there is no “debt relief income” taxed.

Assuming the property is in California and the loan was not refinanced after the purchase, an example of a non-recourse loan is a loan obtained to purchase a personal residence (owner occupied) 1-4 unit residential or any seller carry back real estate loan secured by the property being sold (other restrictions apply).

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Exemptions to the debt relief income

Some exemptions from the debt relief income are when the borrower is discharged of the debt through bankruptcy or the borrower is insolvent. Insolvency means the taxpayer’s debts exceed his or her assets.

1099c issued by the lender after a short sale or foreclosure

The amount shown on the 1099c issued by the lender after the short sale or foreclosure should be carefully inspected to make sure it is correct. When you receive the 1099c, it is important for you to discuss the situation with a trained professional tax advisor. If you prepare the income tax return by yourself, there is a good chance that the amounts shown in the 1099c won’t be handled correctly, resulting in you paying way too much income tax; being audited or having to pay penalties and interest and other consequences.

More information

To obtain more information on the subjects covered above visit the Internal Revenue Service (IRS) web site which has free detailed publications on many tax related subjects. You can also call the IRS Tele-Tax system 800-829-4477, which is an automated voice message information system with recorded information on many commonly asked tax questions. And you may also contact a tax professional.

Information partly provided by the California Association of REALTORS®

Comments

4 Responses to “Taxing Short Sales and Foreclosures”

A Homeowner’s guide: Short Sales and preventing Foreclosure Pt4 (The ramifications) : My Home is My Investment on November 1st, 2007 1:34 pm

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[...] who sold their properties as short sales or lost their homes in foreclosure could’ve been on the hook with the IRS. After HR 3648 passed into law on December 2007, the tax liability was eased on struggling [...]