Tax Consequences of a "Short Sale" of Real Estate vs. Foreclosure

Due to the most significant recession since the 1930's and record unemployment, our nation is now experiencing the ramifications of declining consumer income and plummeting home values. With increases in interest rates for adjustable rate mortgages and the conversion to amortization of principal for interest-only (or negative amortization) loans, home values are collapsing, and the debtors are either trying to "walk away" from their homes and allowing them to be foreclosed or are making "short sales."

How are foreclosures (and deeds in lieu of foreclosure) taxed for IRS purposes?

A vital consideration in establishing the federal tax consequences of a foreclosure (or a deed in lieu of foreclosure) is whether the debt is "recourse" or "nonrecourse." If the debt is "recourse," the debtor is personally liable for the debt. If the debt is "nonrecourse," the debt is solely secured by the property, and the debtor is not personally liable for any outstanding balance. The lender cannot initiate litigation against the debtor for any deficiencies in non recourse debt. Most home loans are recourse debt.

In establishing your particular tax consequences resulting from a foreclosure, you should consult with an attorney to determine whether or not your mortgage is recourse or non-recourse.

When a nonrecourse mortgage is foreclosed on, the subject property is treated as being sold for the balance of the mortgage. This is important because the gain from a foreclosure of a principal residence may be eligible for the $250,000 ($500,000 for jointly-owned marital property) exclusion.

As for recourse mortgages, Congress passed H.R. 3648, the "Mortgage Forgiveness Debt Relief Act of 2007." The legislation is effective for discharges of indebtedness on or after January 1, 2007 and before January 1, 2010. The Federal Bailout Legislation H.R. 1424, passed on October 3, 2008, extended this relief through December 31, 2012.

Under the new law, a discharge of "qualified principal residence indebtedness" is excluded from taxable income. "Qualified principal residence indebtedness" is acquisition indebtedness secured by the principal residence of a taxpayer as defined for the deduction of residential mortgage interest, but the limit is $2,000,000 for the exclusion ($1,000,000 for the mortgage interest deduction) and $1,000,000 for married persons filing a separate return ($500,000 for the mortgage interest deduction). Also, the exclusion only applies to a mortgage secured by the principal residence of the taxpayer.

The exclusion does not apply to investment properties and discharges relating to services to the lender or any other factor not related to a decline in the value of the residence or the financial condition of the taxpayer/borrower. A discharge of indebtedness relating to the foregoing will result in taxable income to the debtor. However, such "phantom income" realized by the debtor (and the income taxes thereon) may be subsequently addressed by filing an Offer In Compromise with the IRS on Form 656. There is no guarantee, however, that the resulting taxes will be partially abated or abated in full. The success of a typical Offer in Compromise is contingent on the collectability of the taxpayer or the viability of the actual assessment itself.

It is worth noting that owners of investment properties often have accumulated suspended passive activity losses that can be applied against the "phantom income" from a debt cancellation with respect to the investment property.

Losses from the sale of income-producing properties may be deductible as ordinary losses under Internal Revenue Code Section 1231. (The loss is reported on Form 4797.) The loss may offset cancellation of debt income ("phantom income"). If the property isn't income producing, the loss may be a capital loss, limited to capital gains plus $3,000.

What happens with a "short sale"?

Short sales are taxed under the same rules as foreclosures.

Recourse debt cancellation is not satisfied with the surrender of the property, so any debt not satisfied with the sale proceeds would be taxable as cancellation of debt income, except for certain "qualified principal residence indebtedness."

View Information For Questions & Answers On Home Forclosure & Debt Cancellation From IRS

The devil is in the details and every case is unique. If you have enough income to save your home, the Firm can design a legal game plan to pursue that goal. If you are not sure or if you just want out, the game plan can include an “exit strategy” that will minimize your personal liability to your creditors, your income tax liability and the damage to your credit rating.