There are definite tax consequences of short sale and foreclosure by lenders for distressed property owners. Many people have been experiencing the loss of equity in their homes as a result of the decline of home values the past few years. Some have even made the decision to walk away from their homes even if they can afford the payments because they know they cannot recoup their equity loss. The lender ends up writing off the losses and selling the property at a foreclosure sale or buying it back and offering it for resale as a REO. When mortgage debt is forgiven, it is considered reportable income. However, there are exceptions to this rule.
One such exception is for taxpayers that receive debt forgiveness on their primary residence from a short sale or foreclosure.Under The Mortgage Debt Relief Act of 2007, taxpayers are discharged from debt and do not face tax consequences of short sale involving debt forgiveness on their principal residence or a mortgage modification. This relief applies for tax years 2007 through December 31, 2012 for up to $2 million dollars in forgiven debt and $1 million for tax payers filing separately.
Prior to enactment of the Act, the debt forgiveness would have been treated as taxable income. It has not been determined at this time whether the Act will be extended or just expire at the end of 2012.You can find more information about debt relief and The Mortgage Debt Relief Act of 2007 by visiting the IRS’s website at http://www.irs.gov/individuals/article/0,,id=179414,00.html.
Another exception to the rule is when you file bankruptcy. Debts that are discharged through bankruptcy are not considered taxable income. However, the decision to file bankruptcy is used as a last resort and should not be taken lightly. It is best to speak with a bankruptcy attorney if you are contemplating filing for bankruptcy.
Certain farm debts are not considered taxable income either. For instance, if you incurred debt as a result of operating a farm and more than half your income for three year’s prior was from farming, if your loan was cancelled, you will not have to pay taxes on the debt forgiveness.
Commercial or Investment Property Tax Consequences of Short Sale
However, if you own commercial property, other investment property or a second home or vacation home, you may be subject to paying tax on the forgiveness of the debt in a short sale situation, mortgage modification or foreclosure. The lender is required by law to report the amount of debt forgiveness to the IRS if the amount exceeds $600 by giving you a Form 1099-C, Cancellation of Debt. So if you purchased a property for $200,000 and sold it for $100,000, and owed $50,000 to the lender, the $50,000 in debt forgiveness may be subject to federal income taxes.
Before you decide to sell your property with a short sale or obtain a mortgage modification, you should consult with your tax advisor. You could also be subject to a deficiency judgment against you by the lender for the difference between the sale proceeds and what you owe on the loan balance. To avoid a deficiency judgment, you should negotiate with the lender that the sale proceeds satisfy your mortgage debt. Not all states allow deficiency judgments. It is a good idea to check with your attorney.
Tax consequences of short sale aside, a short sale may also affect your credit score if you were delinquent in making your payments prior to the property being sold as a short sale. Short sale is a solution for distressed homeowners, but you consider the tax consequences and how it will impact other aspects of your life before you decide to sell your home with a short or walk away from your home.