Short sales raise tax questions

Published on 11/18/07 in the NCTimes

Do you owe more to your bank than your home is worth? You are not alone. In fact, falling prices and the need to sell are pushing many into foreclosure, with the banks taking over the properties. If you are facing this harsh situation, you may have been approached with the idea of a "short sale." A short sale involves negotiating with your bank to reduce the amount owed before completing a sale.

Before you consider this option, you need to be sure that you are not opening yourself up to a tax trap. One problem is that obtaining a reduction in your debt is considered income that stands all by itself. You must frequently report it as a separate transaction and will receive a 1099-C form reminding you of this.

The "C" refers to "cancellation." Unless you meet certain exceptions, such cancellation of debt is treated as ordinary taxable income.

One exception that allows you to dodge a tax hit resulting from a short sale comes into play if you are "insolvent" or in bankruptcy at the time of the sale. The IRS defines being insolvent as having total liabilities that exceed total assets after the debt is discharged.

Another exception is more technical. It hinges on whether or not the debt being canceled is "nonrecourse." Nonrecourse debt in California generally refers to debt used to buy your home. Having part of such debt canceled should not result in a tax problem. On the other hand, when you refinance and borrow funds against your home that are used for other purposes, it could change the nature of the debt so that it becomes recourse debt. It is somewhat rare to find a lender trying to enforce this recourse by going after the borrower's other assets, especially if it is a short sale. However, debt cancellation of recourse indebtedness may result in taxable income.

A short sale transaction may also interfere with being able to exclude a gain from the sale of your residence. Like others, you may have refinanced your home over the years, using the borrowed funds on autos or other personal expenses. The resulting debt may, as a result, far exceed the basis used to calculate a gain. Going through foreclosure generally means that you are selling the home for the total owed against the property. This could result in a capital gain, even though you do not receive funds. If you have owned your home and lived there for two out of the last five years, you should be able to exclude such a taxable gain of up to $250,000 if single and $500,000 if married.

In contrast, when there is a short sale that involves cancellation of recourse debt, the cancellation part of the transaction is treated separately and usually does not qualify for the gain exclusions associated with selling a home. A complicating issue comes up in cases where there is a second trust deed, since such secondary loans are generally wiped out without being considered part of the sale.

Unfortunately, if you lose money on the sale of your home, there is no tax benefit. You cannot deduct the loss or use it to offset the debt cancellation income. One reason that drives people into short sales is that they hope to salvage their credit. This makes sense, since having a foreclosure on your record is a serious issue. However, a short sale does not solve this issue completely, since most banks will not go this route unless you are already a few months behind on your payments. Your credit will be damaged regardless.

Nevertheless, in many cases, a short sale results in the lender granting a full release and satisfaction of the unpaid debt.

Winding its way through Congress and heavily supported by the nation's Realtors is the Mortgage Cancellation Tax Relief Act of 2007. This legislation would amend the Internal Revenue Code to exclude from gross income amounts attributable to a discharge of indebtedness incurred to acquire a principal residence. It seems to apply the rules already in effect in California to the rest of the country, and it does not seem to offer much help to those in California who are being squeezed right now.

Due to these rather confusing rules and frequently unexpected tax outcomes, it may be advisable to ride out the foreclosure process instead of entering into a short sale. In any case, you need to understand the tax effect before you act and to get solid tax advice to guide you through the land mines. Many thanks to Mark Larson of CaliforniaRealEstateSolutions.net for help on this article.