Many people are unaware of the potential tax consequences of a short sale (or foreclosure). A short sale involves selling a property for less than the amount owed to the lien holder. The tax code considers a short sale a “Debt Cancellation”. When a lender cancels or forgives a debt, the difference between what the lender was owed and the amount they received to cancel or forgive the debt may be taxable. For example, assume you owe $250,000 on a mortgage and subsequently sell the property via a short sale for $200,000 and receive forgiveness for the $50,000 difference — this amount could be taxable income.
Loan modifications — renegotiating a loan — that result in a reduction in the loan balance may also be taxable. Effectively, a reduction in the balance of the loan may be taxable as forgiven indebtedness. Foreclosures may also result reportable income.
Luckily, the Mortgage Debt Relief Act of 2007 allows many homeowners to exclude the forgiven debt in many circumstances. Several conditions must be met for the forgiven debt to be excluded form income. First, the indebtedness must have applied to a qualified principal residence. Second, the indebtedness must had been secured by the residence. The amount excluded from income is limited to $2 million for married taxpayers or $1 million for single taxpayers. Finally and perhaps most important, the debt must be forgiven in calendar years 2007 through 2012.
For homeowners considering short selling their home, the tax consequences may be significant. If the amount of forgiven debt is $100,000, there may be no tax consequences if the closing occurs this year (2012). If it closes in 2013, the $100,000 may be taxable and depending on an the marginal tax rate, could result in tens of thousands in taxes due.
Of course there are forms and additional rules to be considered. More details can be found on the IRS website — it included links to the required forms and complete information on what debts qualify. Of course each person’s circumstances vary and consulting with your tax professional is advised. If you have questions about the short sale process or are considering a short sale, give me a call at 303-402-6000 or email me email@example.com