Short Sale and Taxes FAQ
By now, many have seen the “Form 1099-A” and “Form 1099-C” sent out by lenders to persons whose homes have been seized in foreclosure, surrendered through a deed in lieu of foreclosure, or sold in so-called “short sales.” This Q&A is intended to help you understand the tax consequences of such transactions.
Will I have to pay tax if I do a “short sale”?
First of all remember that, for tax purposes, the IRS (and the state) treat a “short sale” the same as any other sale. First, a calculation needs to be done to see if there is “gain” (profit for tax purposes) on the sale. Second, in the case of a “short sale” (or foreclosure or surrender by deed in lieu which are all the same for tax purposes), another calculation needs to be done to see if there is “cancellation of debt” (COD) income --- taxable income resulting from the lender forgiving the debt of the borrower.
Can you give me an example? (Example #1)
Let’s take a typical example in today’s marketplace: John Doe bought a house as his personal residence in 2006 for $500,000. Now the house is worth only $400,000, but he has a loan balance of $500,000 since he took out an interest-only mortgage. He owns a car worth $10,000 (paid off), and has $1,500 in his bank account, $5,000 in clothing and furniture, and a $3,500 retirement plan (a total of $20,000.) Since he lost his job, he cannot pay the mortgage.
If John succeeds in getting bank approval of his short sale for $400,000 and also gets the bank to forgive the remaining balance of $100,000, he will have “cancellation of debt” (COD) income of $100,000. The bank will report this COD income to the IRS, and to John, on a “Form 1099-C” at the beginning of the following year. (The amount of debt cancelled will show in Box 2.)
Will John have to pay income tax on that $100,000?
Not in this case. A new federal law was passed at the end of last year which covers 2007, 2008 and 2009 so that John will not have to pay income tax on COD income of up to $2 million.
What are the requirements?
First of all, the loan forgiven has to be on John’s principal residence. It is important to remember that it cannot be on property he holds as an investment.
What if John owns more than one house?
Under the law, there can be only one principal residence. As such, if the debt is forgiven on any of the other houses, they may not eligible for the exclusion under the new law.
What if John had abandoned the property that had been his principal residence and moved into another place?
The law states that if John used the house as his principal residence during any two of the past five years, it will qualify.
What are the other requirements?
This is very important: To qualify the debt forgiven must be for a mortgage used to “buy, construct, or substantially improve” the property, or refinance the same. If the taxpayer used part of the proceeds of a refinance to pay off credit cards, car loans or for other personal uses, it will not qualify under the new law.
Can you give me an example of a refinancing that fails to qualify under the new law? (Example #2)
Going back to John’s example, let’s change the facts. Let’s say he had originally purchased the house for $300,000, and after it appreciated he refinanced it for $500,000, and paid off the original $300,000, used $80,000 for improvements to the house, and kept the other $120,000 for himself to pay his credit cards, car loans, debts to friends, and also take a vacation. If the lender forgives the loan, $380,000 will qualify under the new law’s exclusion, but the other $120,000 will not.
In that case then, how could John avoid income tax on his COD income?
The law provides for other situations where the taxpayer can exclude COD income. Among the major ways:
- Cancellation of the debt in a bankruptcy case. If John files bankruptcy, surrenders the house to the bank during the case, and cancels the mortgage debt through the bankruptcy (instead of voluntary forgiveness of the debt by the lender) it will be fully excluded from taxable income.
- Cancellation when the taxpayer was insolvent. John can avoid COD income to the extent he is insolvent. Let’s change the facts in Example #1, and say that John also has $30,000 in credit card debt. In that case, he is insolvent to the extent of $110,000 (asset total of $420,000 and liability total of $530,000). Since John’s insolvency of $110,000 is greater than the COD income of $100,000, it is completely excluded from taxable income. (Query, however, whether the short sale alone will help him when it is not addressing the credit card debt problem.)
- Cancellation of “qualified real property business” debt. There is an exclusion from COD income for debt forgiven on real property used in a ”trade or business.” However, since the tax law generally distinguishes “‘trade or business” activity from investment activity, this exclusion may not be available for many persons who purchased homes to rent to others, but do not engage in this activity as a full-time occupation.
- Cancellation of a disputed or contingent debt. In some cases, if the debt is disputed by the taxpayer, such as to validity, enforceability or amount, some courts have held that the forgiven debt amount is not COD income. However, each case is different, and this exception may or may not apply.
So there may be tax if it is John’s investment property on which the debt is forgiven?
Yes. If the short sale is of non-personal residence real estate, the debt forgiven will not qualify under the new law.
How much would be due? (Example #3)
Take the facts in Example #1, but this time assume the house is not John’s personal residence. In this case, John is insolvent only to the extent of $80,000. (Asset total of $420,000 and liability total of $500,000). The COD income (the amount forgiven) would be $100,000. Under the insolvency exclusion John could exclude the first $80,000 of COD income, but would have to include the other $20,000 as income on his tax return. Assuming a 25% tax rate, and no other credits, deductions, losses, etc. to reduce his overall tax, he would owe an additional $5,000 that year.
What about the other part of the determination for tax purposes you talked about at the beginning?
Going back to our first point, in this type of transaction, a calculation must be made to determine “gain” (profit for tax purposes). This is done by subtracting “tax basis” from “amount realized” to get the difference.
How is this calculated?
Let’s take the facts in Example #2. Say that this is a typical residential mortgage with a “recourse” note (where the taxpayer is personally liable). John’s “amount realized” is his sales price, $400,000. His “tax basis” is $380,000 ($300,000 original price plus $80,000 in improvements). The difference between the two is $20,000. After the sale, John has “gain” of $20,000.
Will John have to pay income tax on that “gain”?
Not in this case. Because this is his personal residence, under the law he can exclude up to $250,000 of gain from income tax from its sale.
What if the house is not a personal residence but one of his rental houses?
Now, that gain will be includable in his taxable income and he may have to pay capital gains tax on that amount. Note that if part of the gain is attributable to “depreciation recapture” (reduction in tax basis because of depreciation deductions taken in prior years) that will be taxable at ordinary income rates. At a 25% tax rate, for example, John would have an additional $5,000 in tax at year’s end. What makes this income tax particularly onerous (and “unfair” in the mind of most people) is that John will have to pay tax to the government in cash on “phantom income” he never had in his hands during that year.
So if John’s situation qualifies he can avoid COD tax forever?
Not quite, the exclusion from income tax on COD income may be taxed eventually in some situations. The law requires that the taxpayer take the amount excluded and use it to reduce other tax benefits he may have coming to him. For example, under the new law if the taxpayer keeps his home, such as in a “workout” (where he persuades the lender to voluntarily reduce his principal) the taxpayer must reduce the “tax basis” of the home. At some point in the future, when he sells the house, that amount of COD income he excluded (and by which he reduced his tax basis) will be taxable as ordinary income.
Can you give me an example?
Using the facts in Example #1, let’s say that instead of selling the house for $400,000 and having the bank forgive $100,000, John does a “workout” with the bank so that it reduces his loan principal by $100,000 and John retains the house. In that case, John would have to reduce his tax basis from $500,000 to $400,000. If eventually he sells the house for $550,000, he will need to pay income tax on the $150,000 in profit. (Query whether the first $100,000 of gain, resulting from the reduction in tax basis, would be taxed under ordinary income tax rates or capital gain.)
Likewise, if he avails himself of the other exclusions, such as bankruptcy, he will need to reduce other tax benefits (but only if he has them) such as net operating losses, general business credits, minimum tax credits, or the tax basis in other property owned by him. As such, the exclusion eventually may be captured as income in the future (although this would be at a point in time when the taxpayer liquidated the asset and had funds in hand from which to pay the tax). (See the calculation for this in the instructions to Form 982.)
What tips do you have?
Keep in mind that “one size does not fit all.” The new law does not apply in all situations. If the debt to be forgiven is not the original loan used to purchase, but a refinance, you will need to check how the proceeds from the last refinance were used. Be aware also as to the type of property that is the subject of the short sale. If it is not the principal residence, the new law will not apply. Finally be aware that other exclusions may be applicable. However to determine what exclusions are available one must gather the facts, get the numbers and run the calculations.
List of sources:
- H.R. 3648, “Mortgage Forgiveness Debt Relief Act of 2007.”
- “Mortgage Workouts, Now Tax-Free for Many Homeowners; Claim Relief on Newly Revised IRS Form,” IR-2008-17, Feb. 12, 2008, (IRS Press Release).
- “Questions and Answers on Home Foreclosure and Debt Cancellation,” an IRS Q&A, available at http://www.irs.gov/newsroom/article/0,,id=174034,00.html.
- Statement of Deborah A. Geier, Professor of Law, Cleveland-Marshall College of Law, Cleveland State University, before the Senate Committee on Finance, at a hearing on “The Housing Decline: The Extent of the Problem and Potential Remedies.”
- “Mortgage Forgiveness Debt Relief Act,” an IRS Q&A, available at http://www.irs.gov/individuals/article/0,,id=179414,00.html.
- IRS Form 982 (Rev. February 2008), and its instructions.
- Internal Revenue Code Sections 108, 121, 163(h)(3)(B) and 1001.
- IRS Publications 908 (Bankruptcy Tax Guide) and 504 (Sales and Other Dispositions of Assets)