Forgiveness of Debt on Short Sales and Capital Gains on Trustee Sales:
This topic is so important today because of the number of homeowners receiving Notices of Default and the value of their property is less than their loans. These people need as much information as possible when they are evaluating short sale vs. foreclosure and other options. Anyone who is not a tax professional should not offer tax or legal advice. I am not giving you tax or legal advice. I am giving you sources of information that may help you.
Hot Off the Press:
The IRS homepage www.irs.gov has a new section heading "Questions & Answers in Home Foreclosure and Debt Cancellation." Tell everyone about this section, it will help anyone who is facing this difficult situation.
A Quick Summary of Foreclosure:
When a homeowner loses a home at a Trustee Sale, the bid amount at the sale is considered the sales price. Any gain is calculated the same was as any typical sale (sales price-basis). If the property is a primary residence, capital gains can be excluded under the provisions of the $250k/$500k rules of section 121. For more information on this calculation download page 4 from publication 523 on the IRS website. On second thought, download all of publication 523, it will answer a lot of future questions.
Short Sales & Forgiveness of Debt:
Many homeowners who sell their homes under a lender approved short sale are surprised when they receive a 1099 for the amount forgiven as ordinary income. Everybody seems to have an opinion on this practice. Many say that the 1099 will not issued. Further many opinions are that the short sale is better credit wise than a foreclosure. It has been my experience that lenders do issue 1099's and the short sale does affect your credit profile in a negative way.
Is Cancellation of Debt Always Taxable:
What does the IRS say? Not always. There are some exceptions. The most common situations when cancellation of debt is not taxable involve:
- Bankruptcy: Debts discharged through bankruptcy are not considered taxable income.
- Insolvency: If you are insolvent when the debt is cancelled, some or all of the cancelled debt may not be taxable to you. You are insolvent when your total debts are more than the fair market value of your assets. Insolvency can be fairly complex and the assistance of a tax professional is recommended if you believe that you qualify for this exemption.
- Certain farm debts: If you incurred the debt directly in the operation of a farm, more than half your income for the previous 3 years was from farming, and the loan was owed to a person or agency regularly engaged in lending, your cancelled debt is generally not considered taxable income. The rules applicable to farmers are complex and the assistance of a tax professional is recommended if you believe that you qualify for this exemption.
- Non-recourse loans: A non-recourse loan is a loan for which the lender's only remedy in case of default is to repossess the property being financed or used as collateral. That is, the lender can not pursue you personally in case of default. Forgiveness of a non-recourse loan resulting from a foreclosure does not result in cancellation of debt income. However, it may result in other tax consequences.
A debt is considered "non-recourse" when a loan is made under either of of the following two circumstances:
- The loan was made to purchase a one to four unit property and the borrower intends to occupy one of the units.
- When the seller carrys back financing for all or a portion of the purchase price of any real property.
A Great Publication From CAR:
On September 24th the California Association of Realtors published a publication known as "Taxation of Foreclosures, Deeds in Lieu of Foreclosure, and Short Sales. It is an excellent resource. If you would like a copy, shoot me an email requesting the document and I can forward it to you.
Currently there is a bill in Congress, HR 3648, the Mortgage Forgiveness Debt Relief Act of 2007 that would eliminate a provision of the tax code that allows the IRS to tax debt that is forgiven as ordinary income. Realtors and home builders are supporting this legislation.