Tax & Business Insights

Tax Aspects of Short Sales of Homes

Volume 21 Issue 1 --  January/February 2009

Prior to the recent downturn in the U.S. economy, the term “short sale” was used almost exclusively in connection with sales of stock and other securities.  Recently, however, the term “short sale” has become the lingua franca for selling a residence or other real estate for less than the amount of the mortgage debt on the property.

Let’s assume that Ms. Ena Hole purchased a home as her principal residence. Today, the mortgage debt balance is $400,000, while the home is worth only about $300,000.  Unfortunately, Ena was unable to continue making the mortgage payments and lost the home in foreclosure.  At the time of the foreclosure, the bank took over the property, sold it at a foreclosure sale for $325,000, and issued Ena a Form 1099-C reflecting that $75,000 of mortgage debt had been forgiven. 

An old concept of taxation is that if a debt is partially or totally forgiven, the amount of debt forgiven is generally taxable income to the person receiving the forgiveness — in this case, Ena.  Normally, unless she were insolvent or in bankruptcy, the amount of the income forgiveness would be taxable to Ena, and she would have to include that amount on her tax return as ordinary income. 

The concept of income from forgiveness of indebtedness is foreign to many taxpayers who feel that, after losing money on the transaction, having to pay tax on the amount forgiven seems like adding salt to the wounds of bad luck. As a result, many taxpayers find the concept of income from forgiveness of debt difficult to fathom.

In 2007, Congress amended § 108 of the Internal Revenue Code (IRC) to prevent the situation of what is now referred to as a “short sale” of a principal residence from creating taxable income to the seller. This change applies through 2013.

Sometimes in this newsletter we have used the term “home,” but the new law applies only to a “principal residence.” Not only is the new law limited to “principal residences,” but it also applies only to debt used to acquire or improve such residences. If Ena had refinanced her original mortgage or taken out a second mortgage or home equity line of credit  and used the extra proceeds to purchase a car or pay off credit card debt, that non-acquisition debt will not be covered by the new law. Any forgiveness of that debt will be taxable under the prior rules, unless Ena is insolvent or in bankruptcy.

Real estate lending practices vary throughout the country, but in many states foreclosure of a home does not, by itself, discharge the debt due to the mortgage lender. In other words, even after the foreclosure, the borrower may be liable for the difference between the amount of the mortgage balance and the amount received by the lender (the bank). This could result in what is often called a “deficiency judgment.”  In such cases, there is no “income from forgiveness of debt” so long as there is a possible deficiency judgment.

One cost for the new law’s tax benefit is that there is a reduction in tax attributes, in this case the basis in the home. The new law requires that any debt forgiveness that is excluded from income must be used to reduce the taxpayer’s basis — the cost — in the home for income tax purposes. This also requires the filing of a special form, Form 982, to report the exclusion of the debt forgiveness income and any basis reduction. 

The application of the required basis reduction in cases of debt forgiveness without foreclosure seems relatively straightforward, but how the basis reduction will work when the taxpayer loses the home through foreclosure is not yet clear.

This basis reduction could also have effects when a home is eventually sold. IRC § 121 allows a couple to escape income tax on up to $500,000 of gain on the sale of a principal residence. If the cost basis in the home is reduced as a result of debt forgiveness, then there is an increased chance that a subsequent sale of the home, perhaps when the market recovers, could generate taxable gain. 

As noted above, the new law applies only to “principal residences.” It has no application if other property, such as rental property or property bought for speculation, is sold short or lost in foreclosure.

Many homeowners incorrectly believe that because they have lost money on the sale of their home they should be able to claim a loss on their tax return.  The sale of a home that was earlier converted to rental use can, in some situations, result in a business loss. But Ena will not get a loss on the sale of her home, no matter how far Ena goes “in a hole.”

If you or a client have questions related to this topic, keep The Tax and Business Professionals in mind.

Copyright 2009
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