Tax Consequences On A Short Sale or Foreclosure
** We are not tax experts. The information and examples provided below are for informational purposes ONLY. It will serve in a starting point to further investigate how a short sale or foreclosure may effect your taxes. We HIGHLY RECOMMEND that you consult a CPA and tax adviser regarding your tax obligations BEFORE you consider a short sale, deed-in-lieu-of-foreclosure or foreclosure. **
A tax accountant we highly recommend is Dave Ruch of BRN Tax Accounts
One of the top questions we receive from homeowners considering a short sale or foreclosure, is "What about taxes?". This page is to serve as a starting point on gathering information. As stated above, we are not tax experts and cannot provide tax advice. We have an excellent tax accountant that we highly recommend. You can view his profile HERE and we highly recommend you contact him or your tax accountant/attorney with any questions regarding taxes.
What are the tax implications of a Short Sale or Foreclosure?
Short Sale: When a lender or lenders, agree to a short sale and sell the property for less than the full amount due, the amount of the debt that the lender writes off will be treated as ordinary income for the seller. In order to write off the debt, the lender(s) will be required to file a 1099C (Cancellation of Debt ). The 1099C is what the homeowner receives at the end of the year and must report as income.
A 1099C will always be received from the first mortgage and will only be received from the second mortgage if they agreed to write off the remaining balance of the loan.
Example 1: Assume you purchased your home for $500,000. When you purchased the home, you took a first and second for a total of $450,000. Circumstances in your life put you in a position that you are no longer able to make the payments and now need to sell your home. Due to the decline in the market, you are only about to sell for $400,000. Your lender agrees to the transaction, taking less than is owed and forgiving you of the $50,000 loss.
Enter the IRS. When the mortgage company forgives the difference, the IRS considers the $50,000 that was "forgiven" by the lender as "debt relief" income. Your lender will send you a 1099-C in the amount of $50,000 and the IRS will want you to pay taxes at the rates for ordinary income, same as for salary.
Foreclosure: In a foreclosure, the lender will write off the remaining debt owed on the loan in the same manner as a short sale, and the amount of the debt that the lender writes off will be treated as ordinary income for the homeowner. The lender(s) will be required to file a 1099A (Acquisition or Abandonment of Secured Property), in the case of foreclosure.
In foreclosure, A 1099A will always be received from the first mortgage and will only be received from the second mortgage if they agreed to write off the remaining balance of the loan.
Example 2: Assume you purchase a home for $500,000 and uses it as a personal residence. When you purchased the home, you took a first and second for a total of $450,000. Circumstances in your life put you in a position that you are no longer able to make the payments causing you to default and the lender forecloses on the property. Similar homes at the time sell for $400,000.
Enter the IRS. When the mortgaged property is foreclosed or repossessed, and the bank re-acquires it. The bank sends a Form 1099-A to the owner and the IRS. Using the numbers in the example, the 1099-A indicates the foreclosure bid price ($4000,000), the amount of your debt ($450,000), and whether you were personally liable. Debt cancellation ($50,000) is taxed at the rates for ordinary income, same as for salary.
These are both simplistic examples and most cases are more complex, but the bottom line is that you need to be aware of the potential tax liabilities involved in a short sale, deed-in-lieu-of-foreclosure or foreclosure, and need to speak with a qualified tax professional.
Will I have to pay taxes on the amount of the 1099?
Each homeowner's situation is and you may or may not be subject to taxation depending on different circumstances.
Many owners are able to avoid taxes through one of three ways: "Insolvency", the "Mortgage Forgiveness Debt Relief Act of 2007", or if the loan is a "non-recourse" loan.
Mortgage Forgiveness Debt Relief Act
Under the Mortgage Forgiveness Debt Relief Act of 2007 (H.R. 3648) signed by the President on December 20, 2007, IRS code §108(a)(1)(E), provides that a taxpayer will not be taxed upon cancellation of debt income if the following conditions are met:
- The property sold in the short sale is the taxpayer's principal residence, as that term is used in IRC §121.
- The cancellation of debt is Qualified Principal Residence Indebtedness** under IRC Section 163(h)(3)(B).
- Applies to debt forgiven in calendar years 2007 through 2012.
*** The simple definition of a Qualified Principal Residence Indebtedness is a the original loan that was used to either purchase or build the residence.
If you would like to read the entire Mortgage Forgiveness Debt Relief Act of 2007 (H.R. 3648) bill you can view it HERE.
Previously, the Mortgage Forgiveness Debt Relief Act of 2007 (H.R. 3648) only applied to tax owed to the federal government. In April of 2010, the governor signed Senate Bill 401 (SB401), which provides for relief of paying state taxes on debt forgiven by a lender. The qualifications of SB401 are very similar to the Mortgage Forgiveness Debt Relief Act and should also be discuss with a qualified tax professional. (View further info HERE)
For individuals that do not qualify for the Mortgage Forgiveness Debt Relief Act, there may be another option for avoiding taxes after a short sale or foreclosure, and that is by showing "insolvency". The term “insolvent” simply means that your debts exceed the value of your assets. If you are in a situation where a debt settlement is necessary, you are probably insolvent. In other words, you would have a negative net worth where your liabilities outweigh your assets.
To let the IRS know about your insolvency, you must fill out IRS Form 982: Reduction of Tax Attributes Due to Discharge of Indebtedness. IRS form 982 says, “Generally, the amount by which you benefit from the discharge of indebtedness is included in your gross income. However, under certain circumstances described in section 108, you may exclude the amount of discharged indebtedness from your gross income”. The specific instructions are contained in section 108 of the Internal Revenue Code.
One of the “circumstances” they are referring to is that if you are insolvent before you conduct a short sale then you may be able to “exclude” the forgiven indebtedness (the amount the lender forgave on the loan) from being added to your gross income for that year.
You can find Form 982 here.
Put simply, a home loan may be "non-recourse" if it is the original loan that was used to purchase the property. Once a loan has been refinanced, it is no longer "non-recourse".
In California, according to Code of Civil Procedure § 580b, a loan is non-recourse when either: (1) The loan is a result of seller carry back financing for all or part of the purchase price for any real property; or (2) The loan is made to purchase a dwelling for not more than four families (1-4 units) given to a lender to secure payment of a loan which is used to pay all or part of the purchase price of that dwelling occupied entirely or in part by the purchaser. (Code of Civil Procedure § 580b.) When a loan is non-recourse, if a borrower does not pay, a lender can take back (foreclose) on the collateral, but cannot sue the borrower to be personally liable for the money.
Directly from the IRS regarding taxation:
"A non-recourse loan is a loan for which the lender’s only remedy in case of default is to repossess the property being financed or used as collateral.That is, the lender cannot pursue you personally in case of default.Forgiveness of a non-recourse loan resulting from a foreclosure does not result in cancellation of debt income.However, it may result in other tax consequences." Further information available HERE.
What About Capital Gains?
The final tax issue that any homeowner must consider is Capital Gains. Capital Gains could become an issue for a homeowner that took money out of a property, or who used the property as an investment and depreciated the property.
Even though a short sale or foreclosure occurs because a home owner owes more than the property is worth, they could still be responsible for capital gains. An example this would be if the home owner has owned the home for many years and refinanced their loan(s) during that time to take out equity. After refinancing the property, the owner owes more than the property is worth, but the value may still be above the amount they purchased the property for. This could result in possible "gains" for tax purposes.
For a short sale, capital gain is generally determined by taking the sales price, less the adjusted basis in the property. Adjusted basis is generally the purchase price of the property plus any capital improvements, less depreciation (if the property is investment property). If the adjusted basis exceeds the sales price, then generally there would be no capital gain and there would be a capital loss. (Further information available from the Internal Revenue Service on Home Foreclosure and Debt Cancellation) If the sales price exceeds the adjusted basis, then the borrower generally has a capital gain.
Even if there is a capital gain income on a home, if someone has owned and used the home as their principal residence for periods totaling at least two years during the five year period ending on the date of the sale, the owner may exclude up to $250,000 (up to $500,000 for married couples filing a joint return) from income.
Again, all of the information above is all provided as a starting point and is not tax advise. Please contact a tax professional to discuss your particular situation.
Here are links to two IRS articles that cover Mortgage Forgiveness Debt Relief Act and Debt Cancellation.
IRS - Ten Facts About Mortgage Debt Forgiveness
IRS - FAQ: The Mortgage Forgiveness Debt Relief Act and Debt Cancellation