Don’t Get Caught Short on Short Sale

After the real estate crash, many taxpayers' mortgages exceeded the value of their properties, so they did a short sale or went through a foreclosure. In a short sale the bank will accept less than the value of the mortgage to satisfy the debt, the difference between what the bank accepts and what the property owner owes may be income to the property owner. In a foreclosure the unpaid balance mortgage less the fair market values of the property may be income to the property owner. Many of these taxpayers received Form1099-C, from their banks, showing large amounts of debt cancellation.

Generally, cancellation of debt is taxable income, but due to the magnitude of the crisis, Congress passed a temporary exclusion of up to $2 million for taxpayers who lost their primary residence.  This temporary exclusion expires at the end of 2013, so taxpayers who lose their homes in future years could be stuck with a substantial tax liability. These taxpayers should contact a knowledgeable tax professional who can clearly explain the tax consequences of short sales and foreclosures before surrendering their property.

First, it must be determined if the canceled debt is “recourse” or “non-recourse.” If the mortgage is non-recourse, there will be no cancellation of debt income (CODI), but the taxpayer will be required to treat the transaction as a sale where the gain or loss is equal to the amount of the debt forgiven minus the taxpayer's basis in the property.

For instance, Jimbo owns a house with a basis of $150K subject to a $200K non-recourse mortgage. The house is foreclosed on and Jimbo receives nothing from the sale.  Jimbo will have a gain on the sale of $50K ($200K minus $150K).

When the cancelled debt is recourse, the taxpayer needs to calculate the CODI and the gain or loss on the sale.  The CODI equals the debt forgiven minus the fair market value (FMV) of the property, and the gain or loss equals the FMV of the property minus the taxpayer’s basis.

For instance, Jimbo owns a house with a basis of $150K subject to a $200K recourse mortgage. The house is foreclosed on when its FMV is $75K and Jimbo receives nothing from the sale.  Jimbo will have CODI in the amount of $125K ($200 minus $75) and a loss of $75K ($75 minus $150).  If the house is a rental property Jimbo will be able to deduct the $75K loss; however, if the house is his personal residence, none of the loss will be deductible. The taxpayer then must determine if the CODI can be excluded.

Taxpayers who are insolvent and have gone through a Chapter 11 bankruptcy will be able to exclude CODI under a permanent section of the code, 108(a) (1) (a).If the taxpayer is solvent, however, and the mortgage was for a primary residence, then under the temporary exclusion passed by Congress, 108(h) (1), the taxpayer can exclude up to $2 million of the CODI.

It is important to note that only qualified principle mortgage debt qualifies for the special exclusion. Qualified principle mortgage debt is debt used to acquire or improve the property; therefore, any refinance or home equity loan that exceeds the original principle and is not used to improve the property will not be eligible for the special exclusion.  Only CODI from primary residence qualifies for the special exclusion. CODI from vacation or second homes is not excludable and must be reported as income.

Two other exclusions related to real property used in a taxpayer's trade or business (not rentals) and certain qualified farm debt may be available to solvent taxpayers. Also, taxpayers that use exclusions are usually required to adjust their tax attributes (decrease their tax basis in properties) but when the home mortgage exclusion is used and the taxpayer no longer owns the property no adjustments to tax attributes are required.

Most taxpayers who have gone through a short sale or foreclosure that resulted in CODI are outraged when their tax accountant informs them of their tax liability.  Many will get second opinions or rant about statements their real estate agent made. In cases where solvent taxpayers short-sell their vacation homes, they are usually stuck with large CODI and a non-deductible loss, the worst of both worlds.

About the author - Gregory Fallon, EA provides tax planning and preparation services for individuals and businesses located in the South Bay area of Los Angeles, CA.  For more information about this article, contact Gregory at info@gregfallon.com.