Short sale and foreclosure IRS issues.
Short sales, loan modifications, and foreclosures are all partially related when it comes to the IRS. Please note that what follows is a general discussion and is not to be construed as legal and/or tax advice. If you find yourself dealing with these issues you should obtain competent legal and tax advice. If you reside in Arizona we can help you directly. For other states you may certainly contact us if you wish to see if we know of someone who can help.
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First, what has the IRS got to do with anything? It all relates to the fact that forgiven debt can be considered income. If you borrow $1,000 and are obligated to pay it back then no portion of the $1,000 is income. This applies even if you have temporarily stopped making payments. If the obligation to repay is still there then generally you do not have reportable income.
If, however, you pay back only a portion of the debt (or none at all) and the lender cancels the obligation to pay the rest then the unpaid portion of that money you initially received now becomes income. The fact that you spent it on something makes no difference. You spend a large portion of your "regular" income, right?
Also note that there is a BIG difference between a short sale or foreclosure on a primary residence and either of the same on a rental property. We'll touch on rental property but only briefly as there are simply too many "ifs" for a brief article of this nature.
If you get your lender to do a short sale and they specifically forgive the balance of the loan amount over and above the short sale price then that overage will be reported to the IRS on a form 1099-C (cancellation of debt). Please note that short sales do NOT automatically result in the forgiveness of this excess debt. Many people are of this assumption but THIS IS NOT CORRECT! We'll go over this in more detail in part 3 (deficiency judgments) but for now let's say that your lender forgives the amount above the short sale price.
At this point this is where the differences between a property you use as your primary residence and any other property (2nd home, rental/investment, etc) come into play. For "qualified" principal residence debt the income described above is excluded from tax. This is true on income created via debt cancellation currently thru the end of 2011. Please note the word "qualified" in the above description of debt. Qualified debt is debt incurred to purchase, build, or improve your home. Debt taken on in a re-finance to pay other bills or used for other purposes (credit cards, college, etc.) does NOT apply.
As an example let's say Chris bought a home for $250,000 and he financed $200,000 of the purchase. At some point he refinanced with a $300,000 new loan and paid some bills, bought a car, etc. with the amount over his original $200,000 loan. Today the house is worth $175,000 and for whatever reason Chris can no longer pay his mortgage payment. He hires an agent and a short sale at $175,000 is approved by his lender and the lender agrees to take the $175,000 as payment in full. The lender will not be trying to collect the balance.
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Under this scenario next January Chris will get a 1099-C from his lender showing somewhere around $125,000 in income from this cancelled debt ($300,000 new loan minus short sale of $175,000 equals $125,000 of phantom "income"). Since $100,000 of the new $300,000 loan was over and above his purchase loan of $200,000 and this money was NOT spent on improving/remodeling the home or adding a bedroom or whatnot Chris will be liable for taxes on this $100,000 and it will be treated as ordinary income. The remaining $200,000 of the newer loan (the re-fi) replaced the original purchase loan and is protected. $200,000 minus the $175,000 short sale leaves $25,000 in "income". This income is excluded from tax as qualified principal residence debt so he will have no tax bill on this $25,000. Chris still has to pay tax on the other $100,000 however!
Another example with a less onerous outcome tax-wise follows. Jane buys a house for $250,000 and finances $225,000 of the purchase. Bad things happen and Jane must try a short sale as her house is now worth $175,000 and she can no longer make the payments. Again the bank approves a short sale at $175,000 and forgives the balance. Jane will also receive a 1099-C next January for approximately $50,000 ($225,000 original purchase loan minus short sale price of $175,000) but will not owe tax because the entire amount of debt forgiven was "qualified" debt, in this case purchase debt.
Please note that in Jane's case if her loan was a re-fi of the original amount she'd still have income tax forgiveness. It's the "cash out" part of a re-finance that currently creates IRS liabilities unless the additional money was used on the home to improve it in some manner.
Of course there's much more to this than these simple examples. Additional scenarios need to be taken into consideration including bankruptcy, insolvency (not the same thing as bankruptcy), etc. Even if your example sounds very similar to one of the above you should still seek competent legal and/or tax help.
Additionally, in both of the above examples we are assuming that the property in question was Chris or Jane's primary residence. If they had been rental/investment properties Chris could owe tax on $125,000 ($300,000 total re-fi amount minus $175,000 short sale price) and Jane could owe tax on $50,000 ($225,000 original loan less $175,000 short sale) although both might be able to use the counter-balancing loss realized from the sale of their respective properties to offset these gains. These scenarios need to be thoroughly thought through when deciding what to do with properties that can no longer be paid for. It may very well be that bankruptcy is a better course of action than a short sale or foreclosure. Each case is different.
Lastly it should be noted that this discussion is based on federal taxes. State level issues need to be considered as well.
If your property is in the state of Arizona the author of this article may be able to help you. Irvin Wilson is a licensed real estate broker in AZ. His fee structure is different than most real estate brokers but these types of situations go beyond the understanding of most real estate professionals. Even those self labeled as "short sale experts" should be treated with some caution. There are land mines out there. In all seriousness this is no time to be penny-wise and pound-foolish.
In Part 3 of our short sale/foreclosure series we talk about deficiency judgments on short sales and foreclosures. -back to tutorial index-
Irvin Wilson is a licensed real estate broker located in sunny Scottsdale, Arizona, home of the world's largest attendance PGA golf tournament - The FBR Phoenix Open - which set an attendance record on Saturday's play in 2008 with over 170,000 spectators in one day (538,000+ for the entire tournament). Irvin specializes in income producing and vacation oriented properties. He can be reached by email at iwilson@realmarketexperts.com or by telephone at 1-480-850-1504.
Disclaimer -- Irvin Wilson is not an attorney nor a CPA. Legal and tax information is not legal or accounting advice.
