How a Short Sale Could Lead to a Large Tax Bill

Homeowners who are in the unfortunate position of being “upside down on their mortgage”, a situation that simply means they owe more than the property is worth, might be hard-pressed to think of something that can be worse. This is exactly why homeowners need to be cognizant of all the facts before they make any financial decisions.

What is a Short-Sale?

A short sale is sometimes proposed as a solution to help homeowners who are facing foreclosure. There there are several factors to consider. A short sale occurs when the bank or mortgage lender agrees to allow the homeowner to sell the property for less than the balance outstanding on the loan and the lender also agrees to accept the loss incurred on the deal.

This type of arrangement might sound like it was heaven-sent. After all, the homeowner gets to be free of the loan obligation because the lender generously agreed to accept less than the amount owed. In reality, things are not so clear cut. Firstly, the lender is not necessarily generous, but smart, because they may foresee that their chances of collecting on the mortgage would be much worse if they allowed it to go into foreclosure. Secondly, there is no such thing as a free lunch. The homeowner might receive a 1099-A tax form in the mail and then realize that taxes are due on the forgiven amount.

How can this be? It might seem dreadfully unfair to burden someone who is clearly under financial strain, as evidenced by the loss of their home, with additional taxes owed, but this is the law. The IRS considers the forgiven liability to be income and demands that it be taxed as such.

Short-Sale Example

Putting some actual figures to the equation might make the situation clearer. If Mr. Smith owes $400,000 on his home and it goes under a short sale which manages to realize $300,000, the difference of $100,000 is forgiven under the agreement signed by the lender. However, in the eyes of the IRS, this is the same as a financial gift, because under any other circumstances Mr. Smith would have been required to pay the $100,000 and so he is in effect $100,000 richer. Mr. Smith would then be required to pay taxes on that $100,000.
This matter was looked at before and the result was the Mortgage Forgiveness and Liability Relief Act of 2007, which gives some relief to homeowners caught in this situation. The act is due to expire on December 31, 2012 so there is some time to benefit from its clauses.

When a Short-Sale Is Not Taxable

Under this act liability that is forgiven because of situations leading to foreclosure are excluded as income and so will not be taxable. However, there are several conditions that must apply if the homeowner is to seek refuge from taxes under this act. The stipulations are listed below;

• Second homes and investment properties do not apply for this relief. It is reserved for people defaulting on a mortgage for their primary residence.
• Married persons may be forgiven up to $2 million while single persons can claim up to $1 million.
• Home equity loans of refinanced mortgages are eligible as long as the funds were used to improve the home, or in the case of refinancing, if the loan amount stayed the same or increased. If a home equity loan was used to purchase stocks or other investments or used for any other purpose than reinvested into the property, the amount will not be forgiven.

If you do qualify for liability forgiveness under the act you must still fill out your tax forms and attach Form 982 to support your forgiveness claim.

For those who find themselves in a position where you are responsible for a large tax bill, take the necessary steps to address the situation. This may include talking to a tax professional to determine what options are available to ensure you understand options available to you as well as what actions need to be taken to avoid problems with the IRS.