This is not legal advice. For legal advice, consult an attorney, not a blog. Furthermore, the post below addresses some BUT NOT ALL issues relating to foreclosure, short sale, etc., and the following analysis is cursory and not complete. If you face a foreclosure or are considering some alternative, you should obtain legal advice.
The Senate Finance Committee recently approved extending the Mortgage Forgiveness Debt Relief Act through 2013. That’s GREAT news for anybody interested in a short sale here in Washington. If you’re wondering why…
Generally speaking, the IRS considers as income any forgiven debt (Cancellation of Debt, or COD, income). For example, if I borrowed $50k from you, that would not be “income” subject to taxation because, while I received $50k from you, I had a corresponding liability to you in the same amount. But if you then released me from that obligation and forgave that debt, at that moment I would have realized $50k in “income.” Therefore I would need to report this “income” — the amount of the forgiven debt — on that year’s federal income tax return (and of course pay taxes on it).
In 2007, as the housing crisis was getting underway, Congress passed the Mortgage Forgiveness Debt Relief Act. This act allows homeowners to avoid COD tax liability on debt that was incurred by the purchase of a principal residence. In other words, if the property is your principal residence, then you will not face income tax liability on the forgiven debt.
Here in WA, there is debate about the COD tax implications of a non-judicial foreclosure. The vast majority of foreclosures in this state are of this variety. In a non-judicial foreclosure, the difference between the funds paid at the foreclosure auction and the amount owed is extinguished as a matter of law. In other words, following a non-judicial foreclosure, the owner/debtor neither owns the house nor owes any money to the bank, regardless of what was paid for the property at auction. Accordingly, some — but not all — experts believe that a non-judicial foreclosure does not create COD tax liability.
The Mortgage Forgiveness Debt Relief Act expires December 31 of this year. Thus, if the act is not extended, effective January 1 any forgiven debt, even on a principal residence, will be considered as income and taxed accordingly by the IRS. Here in WA, the only possible exemption to this liability is the argument that a non-judicial foreclosure does not create COD tax liability. Thus, an owner/debtor subjected to foreclosure at least has an argument that he does not have COD tax liability after a non-judicial foreclosure.
But a short sale? As it stands now, beginning January 1 any owner who sells short and is released from the debt will have to report that forgiven debt as income. There is no question that debt forgiven as part of an approved short sale is subject to COD tax liability absent the “principal residence” exemption. In other words, only a confused or misinformed owner/debtor will seek a short sale beginning January 1 given the substantial tax implications. For example, if your house sells for $300k but you owe $400k, you will have to report $100k as income, resulting in a tax bill of an additional $30k or so (depending on your tax bracket). Is a successful short sale worth that kind of money owed to the IRS?
But — and getting back to where we stared — good news is on the distant horizon. Recently, the Senate Finance Committee approved extending the Mortgage Forgiveness Debt Relief Act through 2013. While admittedly a very small step, it is at least a first step towards exending this income tax exemption. And absent such an extension, short sales will become far, far less attractive. If Congress can complete the job — a very big IF — then short sales will remain a viable alternative to foreclosure. But if Congress sits on its hands and lets the exemption expire, short sales will likely dry up dramatically. Or at least they should…