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Short Sales – Tax Perspective

Short sales, principal reduction loan modifications and deeds in lieu of foreclosures all present unique tax consequences, and they vary from one person to another. Much of what we are hearing from clients is informations based on myths surrounding short sales, which can be very misleading and confusing.

Here are 10 Myths –and the corresponding truths– that are extremely common for short sales. Though most of the myths steam from a truth, they have been greatly misconstrued and now make it difficult to find clarity.

Myth #1: “I won’t owe any income tax because this is homestead property.” This myth began with the passage of the Mortgage Debt Forgiveness Relief Act (“MDFRA”) in December 2007, which does provide some relief to those taxpayers who face debt forgiveness (which would otherwise be taxable) relating to their real estate. There are significant limits on the relief, however that can be explained in detail by our Denver bankruptcy lawyers.
Myth #2: “I’ll have a loss on the property, so I don’t need to worry about tax.” Capital losses resulting from the sale of the property will not offset the income resulting from the forgiveness of debt. Also, sellers often believe they have a “loss” on their property when in fact they don’t – selling it for less than you owe isn’t the test. If your basis is less than the debt forgiven, you can actually have a gain. This often happens in the short sale situation, due to the reduction of basis.
Myth #3: “I can use the capital gain exclusion to wipe out any taxable income from the short sale.” The exclusion is a capital gain exclusion only. Income from debt forgiveness is ordinary income, not capital gain. This exclusion is only helpful if a capital gain results from the reduction in the basis of the property. But beware, the amount of the forgiven debt which is excluded from taxable income also reduces the amount of gain that can be excluded under this provision, dollar for dollar.
Myth #4: “I’m in a low tax bracket, so the tax won’t be that much.” Before the transaction in question, the seller probably was in a low tax bracket. If the debt forgiven is large (and it’s not unusual these days to see amounts of $50,000-$150,000 and higher), this increases the seller’s taxable income by that amount. It’s like getting a big fat paycheck that you never see, and it puts many sellers into higher tax brackets than their historical rates.
Myth #5: “I have no assets, so I’m insolvent and don’t need to worry about the tax consequences of a short sale.” This is true as far as it goes: Section 108 of the IRC indeed provides for excluding forgiven debt from income to the extent the seller is insolvent. However, just because a seller is upside down on their property doesn’t mean they’re insolvent for this purpose. The extent of insolvency for IRS purposes is the difference between the outstanding liabilities and fair market value of the assets owned by the seller on the date of the short sale. It is virtually impossible to reach a conclusion on insolvency for this purpose without a detailed analysis of all of the seller’s assets and liabilities.
Myth #6: “I heard that the IRS isn’t going after people due to the economic climate.” Ok, this one doesn’t stem from a grain of truth; it’s just wishful thinking. The IRS is actually increasing its enforcement and collection efforts in the current economic climate. Its primary purpose is to collect revenue; and the government needs revenue as much as anyone else these days.
Myth #7: “I’ll just tell the lender that I don’t want a 1099.”The 1099-C requirement is not negotiable: it’s the law. If the debt is forgiven, the tax liability has been generated. The lender must report it, and so must the property owner (even if they don’t receive a 1099-C by January 31 of the year following the short sale). Sellers can be subject to a 25% reporting penalty if they don’t report the debt forgiveness; this is not one to be taken lightly.
Myth #8: “A friend heard on the news that there is no tax on short sales anymore.” See Myth #1. And stop watching the news and listening to your friend’s tax and legal “expertise”. This can lead to serious confusion and misleading ideas.
Myth #9: “I’ll just let the property go into foreclosure, rather than do a short sale, to avoid the taxes.” This wouldn’t necessarily help you. The tax is the same regardless of how the debt forgiveness comes about: a short sale, principal reduction loan modification or deed in lieu of foreclosure all have the same effect. The only potential difference is the amount of the debt forgiven.
Myth #10: “If I end up owing tax, I’ll just file bankruptcy.” Chances are, you’ll still owe the tax. Income tax is not typically discharged in bankruptcy. While there are a few exceptions, income tax liabilities are assessed over 1095 days from the day your bankruptcy case is filed. A tax discharge report can be obtained and used to argue your case.
The tax implications of short sales are more complex than the mass media would lead us to believe, and there is considerable misunderstanding among property owners as to what the rules are and how they would apply. We hope to dispel the myths by informing you of the actual truth. If you are on the verge of a short sale, be sure to contact our firm today at (303) 893-0833. The attorneys and staff at Roberson Law, LLC are here to help with your case!