Short Sale or Foreclosure – the Income Tax Consequences

We are CPAs in Chicago and provide the following summary for the benefit of Taxpayers in Chicago and surrounding suburbs.

These days a lot of home owners or real estate investors are encountering numerous questions about the tax consequences of these situations. That’s why it’s more important than ever for real estate owners to understand the basics of how the IRS views tax forgiveness.

How does the IRS view a short sale or foreclosure?

short sale is the discount a mortgage holder may allow in order to sell the property, even though doing so will short or discount the note. This generally results in a benefit to the debtor because the mortgage is reduced.

The process, of course, is different in a foreclosure, but the result is essentially the same.  The mortgage holder forecloses on the property, takes possession or sells the property on the courthouse steps, and will probably end up losing on the original mortgage. In effect, the borrower usually doesn’t have to pay the full mortgage, and whatever the lender can get for the property reduces the mortgage amount and the lender will often take a loss on the rest.

IRS frankly doesn’t care if a property is going through a short sale or foreclosure. The IRS is going to determine if Forgiveness of Debt took place and if it should be taxed to the taxpayer. Keep in mind though that the lender does not always forgive debt in a foreclosure or short sale. If the lender gets a deficiency judgment or comes after the homeowner for the unpaid amount, there is no debt forgiveness and thus no taxable income.

However, for situations where the lender does forgive the debt, determining what should be taxed can be a complicated question with lots of variations based on the facts and circumstances.

Keep in mind that, in almost every situation, the IRS boils the transaction down to the analysis of four questions:

.Question 1: Was the property sold for less than the mortgage or mortgages on the property?

Easy to calculate, simply add up all of the debt on the property (first and second mortgages included), and subtract it from the final sales price. If the result is a negative number, then there is a presumption the seller or prior owner is facing Forgiveness of Debt Income.

In case of foreclosure, it’s a little more difficult to determine the amounts in the equation above, because sometimes the bank/mortgage holder hasn’t sold the property yet; they simply took possession of the property in the foreclosure. Essentially, the calculation can’t be completed until the lender sells the property and their loss is determined.

Question 2: Was the mortgage or mortgages considered recourse or non-recourse debt?

If there is a presumption of debt forgiveness as determined in Question 1, the taxpayer next has to find out if the debt is recourse debt. This simply means the debtor signed personally guaranteeing the debt, or in other words, is personally obligated to pay the mortgage. This is actually an easy fact to determine.

A quick document review by an attorney can help the homeowner determine if the debt is recourse or not. The good news is if they aren’t personally liable, then they don’t have to pay the debt and they don’t have Forgiveness of Debt Income.

            Question 3: Is there Forgiveness of Debt Income after the basis on the property and any loss is calculated?

Often taxpayers overlook this aspect of the analysis.  Assuming there is recourse debt, and hence Forgiveness of Debt Income, taxpayers shouldn’t forget to calculate their loss on the property as a whole. This loss can offset any Forgiveness of Debt Income.

In this more complicated equation, the taxpayer would start with the sales price of the property and then subtract the adjusted basis on the property (i.e., the net cost for the property after adjusting for various items like depreciation or home improvements). This process will tell the homeowner if there is a gain or loss on the property. In sum, a loss would be deductible against the Forgiveness of Debt Income. Note, however, that a primary residence is going to be treated differently during this stage of the analysis (see below).

If there is Forgiveness of Debt Income from recourse debt and the loss on the sale doesn’t wipe out the gain, or it isn’t a primary residence, then the taxpayer’s only option to avoid being taxed on the forgiveness is to qualify under the insolvency or bankruptcy rules provided by the IRS. Essentially, these rules require the taxpayer’s total liabilities to exceed total assets, whether married or single (the details of which are discussed in IRS Publication 4681).

One final option that doesn’t allow the taxpayer to discharge the income but permits deferring the tax over time is to reduce the basis on other real estate owned by the taxpayer by using Form 982.

Question 4: Was the property in question the primary residence of the taxpayer?

The rules have been changed when it comes to principal or primary residences. Congress passed and President Bush signed into law the Mortgage Forgiveness Debt Relief Act of 2007 to provide relief to families who were going through a short sale or foreclosure on their primary residence through the end of 2012. This law essentially wipes out any acquisition indebtedness (not second mortgages unrelated to the purchase) and is a specific election made on a tax return. (Note there is a limit of $2 million of interest and debt for married couples and a lower limit for single individuals). Taxpayers should consult with their tax advisor regarding the specifics of this exception and they qualify.

Finally, I would be remiss to not mention loan modifications and the impact they may have on a tax bill. Rest assured, most loan modifications don’t create taxable income as they simply modify the terms of a loan to help a debtor better make his or her payments. However, if a lender actually reduces the principal amount of the loan, sometimes called a cram down, then the debtor better expect a 1099 for Cancellation of Debt Income and speak with a tax advisor.

Make sure your Tax Advisor knows how to apply correctly the tax deductions that are allowed.

In summary, if you going through a loan modification, short-sale, foreclosure, or deed in lieu, please know that, we at TaxCutters can help you through the tax paperwork process.  Please give us a call at: 773-728-1500.