Forgiveness of Debt Tax on Short Sales vs. Foreclosures

by Renee Daggett

The real estate market has been rocky for the past 4 years.  However, there is a law about to expire on December 31, 2012.  If you have forgiveness of debt on your primary residence, you don’t have to pay the tax on the amount forgiven.  However, if you sell your house on January 1, 2013 and have an outstanding loan, you WILL have to pay the tax on the amount forgiven.

Taxpayers facing foreclosure or short sale on their principal residences have been able to avoid some of the income tax that would normally be assessed thanks to the Mortgage Forgiveness Debt Relief Act of 2007.  But that relief is set to end for home transactions that occur after December 31, 2012.

The act will expire at the end of this year; therefore, if you have fallen behind on your mortgage payments and are facing foreclosure or the short sale of your home, it may benefit you to have the transaction completed before 2013. Here are some important facts to understand about foreclosures and short sales.

Understanding Forgiveness of Debt Tax

If you FORECLOSE…

1. You are deemed to have involuntarily “sold” your home, making it subject to taxes even if it resulted in a loss.

2. The IRS will issue you a Form 1099-A showing the balance of your loan at foreclosure and the price the bank was able to sell the house for.  This is often referred to as the home’s market value.  The difference between your original investment in the home and the market value is the gain or loss on the “sale” of your home.

3. You may also receive a Form 1099-C, or Cancellation of Debt, showing the amount of the loan the bank forgave you when it foreclosed.

4. Normally, debt forgiveness results in taxable income.  However, under the Mortgage Forgiveness Debt Relief Act of 2007, you may still be able to exclude up to $2 million of debt forgiven on your principal residence until December 31, 2012.

5. To qualify, the debt must have been used to buy, build or substantially improve your principal residence and be secured by that home.

6. Refinanced debt proceeds used for the purpose of substantially improving your principal residence also qualify for the exclusion.

7. Proceeds of refinanced debt used for other purposes do not qualify for the exclusion – for example, to pay off credit card debt.

Understanding Forgiveness of Debt Tax if you SHORT SELL…

1. You have voluntarily sold your home, and the proceeds from selling the property will fall short of the balance of what you owe on it.  The lender must agree and determines whether to allow the short sale.

2. The lender forgives the balance of the debt on your home by entering into an agreement with you and the buyer.  Your lender may require you to contribute some amount of money in order to go ahead with the transaction.

3. You will receive a Form 1099-S showing the balance of the loan at the short sale and the sale price or market value of the home.  The difference between your original investment in the home and the market value is the gain or loss on the sale of your home.

4. You may also receive a Form 1099-C, or Cancellation of Debt, showing the amount of the loan the bank forgave you when it agreed to the short sale.

5. Again, forgiveness by the lender of the debt usually means you have reportable income.  However, because of the Mortgage Forgiveness Debt Relief Act of 2007, you may still be able to exclude up to $2 million of debt forgiven on your principal residence until December 31, 2012.

6. Refinanced debt proceeds used for the purpose of substantially improving your principal residence also qualify for the exclusion.

7. Proceeds of refinanced debt used for other purposes do not qualify for the exclusion – for example, to pay off credit card debt.

So what if the property you own is a rental?  The IRS says there’s no free lunch here.  Debt forgiven on second homes, rental property, business property, credit cards or car loans does not qualify for the tax relief provision. In some cases, however, other tax relief provisions – such as insolvency – may apply.

If you have the option, seek legal and tax advice BEFORE you sell on a short sale or go through a foreclosure.  Do tax planning ahead of time, before it is too late.  Call our office to discuss your options.

Renee Daggett is the president of Administrative Bookkeeping Co., Inc. She received a bachelor’s degree from San Jose State University in 1989 and is an Enrolled Agent tax preparer (enrolled to represent tax payers before the IRS). Renee is also the author of “Your Financial Flight Plan: Pilot Your Business To Profitability.” In her book, she demonstrates in a creative way the reasons why every business owner needs to be a better manager of his/her business. http://www.adminbooks.com/

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