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…
Pingback: Short Sales Rising Sharply « Livinglies's Weblog
is there any new info on taxes for 2013 on a Foreclosure
Scott, I’m not sure I understand your question. Extension of the Mortgage Debt Forgiveness Relief Act will also aply to debt extinguished by a non-judicial foreclosure. That said and as discussed above, though, you may not need that exemption to avoid tax liability in WA given the nature of our non-judicial foreclosure.
Pingback: Congress Considers Extension of the Mortgage Debt Relief Act (MDRA) Beyond 2012
Great information in this article. Many do not even consider the tax implications when entering into short sales, and obviously they should. This is a great bit of info for anyone considering short sale.
OK, this is great information, and I’m very happy you provided it.
It’s something I think agents should avoid any discussion of, but in my opinion you have raised one, of many reasons that the rush to short sale a property was foolish for many people.
One of the other reasons is that banks also collect financial information when they short a property. I’m wondering if in the future some, or all of that information could be used against the person claiming hardship, or hiding income, or assets, in the short sale process.
David — you are 100% correct. It may not be in a person’s interest to share financial information with the lender when seeking a short sale. And that standard warning, where they they tell you that all information is being used to collect a debt? While not quite a Miranda warning, it’s serious and they mean it. I don’t think we’ll ever know that a bank changed its mind and sued a debtor after receiving the completed “short sale packet” but sure it is a risk.
what are tax implycations on a stright Foreclouser
Scott, as noted in the post (with a link), there is debate here in Washington State on that very issue. So obviuosly you will not get a definitive answer via a blog — or, perhaps more accurately, you surely will not get a definitive answer upon which you can rely. You need to consult a tax professional, whether a CPA or an attorney, for this sort of specific tax advice upon which you can rely.
If you’re talking about a property in a state other than WA, then you’re really off base because this entire post and my entire practice is limited to this state. Again, consult a tax pro in the state where the foreclosure is about to occur.
Finally, you may want to invest in some sort of spell-checker — three misspelled words out of eight might be a new record. 😉
If a person buys a new principle residence, rents their house for awhile and then does a short sale on their old principle residence will they be eligible for exemption of tax liability? The above is assuming that congress does something with this for 2013.
Diane, you’re looking for an answer to a question specific to your situation. You need to consult a tax professional in person, whether now or no later than when you complete the year’s tax return. Rely on advice gleaned from a blog at your peril. Subject to that disclaimer…
I don’t know. The answer to that specific question — a common one — is subject to debate even among people who practice in this area (tax lawyers, CPAs). I don’t practice in this area so I won’t even hazard a guess. I suggest you consult a CPA now so you can plan on whatever liability, if any, you can expect to incur in the future.
If i start a shortsale in 2012. Receive the offer accept and sign. Wait for bank to agree. If it runs into Jan 2013. Will i fall under 2013 laws or 2012 since the contract was initiated then? I heard it can take up to 6 months. So Now I am worried. My realtor said perhaps it can be done prior. I am not happy w perhaps..if he’s wrong i pay.
Are there any incometax benefits to lenders which agree to short sales on their portfolio morgage loan losses.
Mari:
It is not that simple. I suggest you contact a tax professional, not a blog, if you want to know your anticipated tax liability. Moreover, what follows is not legal advice and I am not your attorney. Subject to those disclaimers…
Per the terms of the short sale approval letter (presumably!) the debt will be forgiven upon receipt of the funds shown in the letter. And forgiveness of the debt is the taxable event. So your tax liability is determined based on the closing date.
orest e bliss, I have absolutely no idea. That is very far afield from my area of practice, consumer-oriented residential real estate. Subject to that disclaimer…
I dunno — do bad debts, i.e. written off, confer any tax benefit? I think so, but that is a rank guess.
Are there any update for 2013?
I have a hard time seeing how a short sale could be considered COD income.
If you purchased a home 5 years ago for $150,000 and put 20% down, you would have financed $120,000. After 5 years, you default on the loan. Your balance would be about $111,000 (at 5.5% APR). Let’s say the property sells for $100,000.
This would mean that, according the IRS, you would have “income” of $11,000. However you paid out of pocket $30,000 as a down payment. In addition, you no longer own the house as it was repossessed by the lender. How they can say the homeowner “earned” money is beyond me.
I guess this comment is now mute – at least for 2013 because on January 1st, Congress signed the H.R. 8, the American Taxpayer Relief Act of 2012. The mortgage cancellation relief for home owners or sellers who have a portion of their mortgage debt forgiven by their lender, typically in a short sale or foreclosure sale for sellers and in a modification for owners is extend through 2013.
Additionally, deductions for mortgage interest, mortgage insurance premiums and state and local property taxes, are extended. The exclusion from capital gains with the cap at $500,000 ($250,000 for individuals) remains in effect (subject to limitations).
This is good news for the real estate industry. Now we just have to make sure that we try not to repeat the financial crisis again. To see what we can do to keep ourselves from foreclosure during 2013 you can check out my recent blog article “Avoid Another Foreclosure Crisis – Take Matters Into Your Own Hands” at http://www.bankforeclosuressale.com/wp/article-01044142.html
Christy, I am unaware of any further developments on this issue.
Simon, the general rule is that forgiven debt is income. Try a simpler hypothetical to first understand the general rule. Assume you loan me $10k. Even though I take in $10k at that moment, it is not “income” becuase I have a matching liability (I owe you $10k). Accordingly, there is no income.
I make payments for a year such that I owe you $8k. Then, out of the goodness of your heart, you tell me that you will forgive the $8k owed. At that moment, I no longer have an $8k liability, but I still received the $8k. So at that moment I have realized income of $8k.
Yes, I agree it gets very muddled when applied in real life. But in your hypothetical, the homeowner/borrower realized income of $11k. Your homeowner/borrower also realized a loss of $50k (difference between purchase price and sale price) that will be treated as a capital loss (I believe). But that loss, resulting from depreciation of an asset, is a different issue than the fact that the borrower was relieved of the debt (and thus realized income of $11k).
This blog post has been an eye opener.
MDRA really needs to be extended to take advantage of all of the streamlining that has been put in place over the past 18 months.
Otherwise, sellers may get to the closing table and refuse to sign… and HELLO FORECLOSURE!
If you have a signed short sale contract by 12/31/12, are you OK if sale goes thru fine even after year-end, or is the CLOSING DATE of the short sale the determining factor? What date in the process trips the taxable event of the debt forgiveness for the short sale seller? VERY IMPORTANT QUESTION AT THIS TIME!!
Diane, a “VERY IMPORTANT QUESTION” needs to be posed to a professional who is providing services to you. Such a question is not appropriate for a blog. Moreover, I don’t practice law via a blog, I am not your attorney, and I will not be giving you legal advice. Subject to that disclaimer…
Debt is forgiven at time of closing. Date of contract is not relevant.
Best of luck.
I started a short sale back in July 2012. the bank took forever to approve and now the house will close in January 2013. I dont believe I should be held liable for taxes when I started this process 5 months ago. Also, I do not understand the tax liability, because, if I had equity in my house and sold it, I do not have to pay tax on the first $250k of profit, so why do I pay on a loss of less than $250k?? makes no sense.
This is not legal advice and I am not your attorney. Subject to that disclaimer…
Edward, you are indeed in a tough spot, and I can appreciate your frustration. That said, the law is the law regardless of what you believe is the “right” outcome. And here is the law: (a) the principal residence exemption to Cancellation of Debt (COD) income tax liability will expire 12/31 (the odds of it being extended are now near zero and drop further every day); and (b) capital losses offset capital gains, not income.
Specifically as for (b), the first $250k in capital gain of a principal residence is tax free, and if you sustain a capital loss that loss can be offset against such gains in the future (I believe 3 years?). But a capital loss does NOT offset income, regardless of whether that is actual income or cancelled debt income. Capital gains and income are two different tax issues.
So while it may make no sense to you, it makes plenty of sense to the IRS and is consistent with the law. Don’t like the law? Write your congressperson….
And if you want advice upon which you can rely, consult a tax professional in person. Don’t rely upon a blog.
I still do not see how the difference between the loan amount ($111,000) and the short sale ($100,000) can amount to $11,000 of income. If the bank handed you $111K cash and you give them $100K back and the rest is erased, then yes, you have received hard currency amounting to $11k and deserve to pay tax.
But in a foreclosures/short sale, the homeowner walks away with nothing in his pocket. The $111k bought the house, but now the bank owns it. No equity left for the homeowner.
If sold on a short sale, the owner doesn’t see any of the sales price. Once again, empty pockets. It just seems like the IRS is kicking a man when he is down… just because he can.
Simon, the bank DID hand you $111k in cash, and you used that money to buy a house. Then, when you defaulted on that loan, the bank foreclosed on the home which is now worth $100k. By foreclosing (nonjudicially) the balance of the money you borrowed — $11k — WAS “erased” by the foreclosure. Yes, there is no equity left for the homeowner because of the vagaries of the market. But that does not change fact that borrower borrowed $111k and repaid $100k, with balance extinguished. And that has always been COD income.
Hi We signed a purchase and sales agreement as well in 2012. Bank dragging their feet on the paper work. Shouldn’t the purchase and sales agreement as dated serve as a 2012 sale?
Jean, I am a lawyer, not a judge or legislator. Accordingly, I focus on what “is” and not what “should be.” And the debt IS extinguished – if at all – at closing, not when the parties sign the sales contract.
Talked to IRS agent today (Mr. Taylor #0228055 who answers the IRS # dealing with real estate complex issues. We have a home in Iowa that has a principle balance of $342K. We are closing on a short sale in late January 2013. The HUD-1 sayd the bank will receive $277,678. My question to the IRS specialist was in regards to our tax liability. He said that at closing (when house moves from us as listed owner to the bank or new owners) we are except from paying tax on the capital gains (mentioned above) if 1 of 3 criteria apply. When the mortgage company provides us a debit cancelation (1099-C) and we 1) are in bankruptcy (which we will not) or 2) living in the home as principle residence (which we are not) or 3) involvent (add up all debt including the house vs. our net value in cash. . if debt exceeds, file 982 with 2014 tax return to exclude the capital gain due to insolvency.
Also, while attempting to sell since July, 2012, we tried to rent it out. They said we can deduct all costs to maintain the home under Schedule E.
I too did a short sale, Bank approval on Dec 14 and possible closing late Jan 2013. The debt is $30,000 but grew to $90,000 after they listed commission, closing, and county taxes. The first $ amount I could probably handle as income but not the second. I don’t think a person can file bankruptcy against the IRS but in an early statement of refusing to sign at closing and letting it go into foreclosure sounds more workable. Not asking for legal advice just your thought.
Moral of the story. Judicial Foreclosure on a NON RECOURSE loan always has been and still remains the way to avoid COD. We need SHORT SALES OFF THE MARKET it is distorting the market substantially.
Thanks
Iowa Pete: I think you are confusing two different and distinct tax issues: Capital gains/losses, versus income due to extinguished debt. I strongly encourage you to consult a tax professional to get counsel as to each of these separate issues so that you can make an informed decision about how to proceed.
Barbara — and all other readers — I have addressed today’s development and moved this thread to my blog.
Oops, I just read Richard’s “moral of the story” and simply must add one post-script reply:
Richard, there is no such thing as a “judicial foreclosure on a nonrecourse loan” here in the State of Washington. A judicial foreclosure renders the loan recourse. So your “moral” is inapplicable to sellers in this state (WA).
Which is a great example of the risks of getting legal information from the internet: There is one internet, but 50 different states each with its own set of laws. What is applicable in one state may not have anything to do with the laws of another. If you rely on legal advice gleaned from the ‘net, consider yourself forewarned…
thank you for that Article. do you have any thoughts as to whether Congress might extend the tax forgiveness on short sales for 2014?
Sorry, David, no idea whatsoever. At this point, with Congress becoming more dysfunctional by the day and with a generally recognized “recovery” underway in the housing market, I am not optimistic that it will be extended yet again. But one never knows….
Pingback: Look For New foreclosure Inventory