Are Taxes Due On A Short Sale – A Short Sale Sample

News Flash – Short Sales No Longer Carry Federal Tax Consequences!

Why? The Mortgage Forgiveness Debt Relief Act of 2007 (H.R. 3648). The Mortgage Forgiveness Debt Relief Act 2007, (H.R. 3648), recently signed into law by President Bush, now excludes discharges of indebtedness on a tax payer’s principal residence for the purpose of calculating the individual’s annual taxable income. Visit the IRS.Gov website to review the Mortgage Forgiveness Debt Relief Act Summary Page

You may have heard that if you lose your home to foreclosure or sell your home through a short sale that you will owe income tax on the forgiven debt. While this was mostly true just a few years ago, the Mortgage Forgiveness Debt Relief Act of 2007 has completely changed the tax liability landscape for homeowners facing foreclosure or a short sale.

Just a few years ago, losing a home to foreclosure or through short sale meant a that a homeowner could face a huge tax burden after all the dust settled.

Consider the following Short Sale Sample:

Let’s say a home owner’s existing mortgage is $300,000, but with the assistance of a qualified REALTOR specializing in Short Sales, the home owner sells the property to a buyer for $200,000. This difference is $100,000 in forgiven debt which used to become taxable income. Something the IRS calls cancellation of indebtedness income.

Continuing with our example, if this home owner’s federal income tax rate is 30%, they would owe the IRS approximately $30,000 in federal income tax, in addition to having the blemish of a short sale on their credit report. Can you imagine the stress of losing your home, and having a huge tax bill on top of that for a home that you don’t own anymore?

Cancellation of indebtedness income tax, or phantom tax as some critics have called it, remained an obstacle for innumerable home owners experiencing financial hardships and considering a Short Sale of their home as an alternative to foreclosure. Many homeowners simply could not afford the additional tax burden assumed by proceeding with a Short Sale. At least that was the case before this new legislation was passed.

Prior the new legislation, however, there were two existing exceptions to the federal tax code relating to the cancellation of mortgage debt. The first exception said that if a home owner is insolvent at the time their debt is canceled, then no additional federal income tax is owed.

What does insolvent mean? It means if the homeowner adds up all their assets, such as cash reserves and the value of other property owned, but excluding many retirement funds, and subtracts all other liabilities and ends up with a negative number, they are technically insolvent. Simply put, if the home owner owes more than they have in assets, they are insolvent.

The second exception involves non-recourse loans. In many states such as California, loans used to purchase a primary residence are typically considered non-recourse, and once again carry no added federal tax liability when sold as a Short Sale or through foreclosure.

Passage of the Mortgage Forgiveness Debt Relief Act 2007 means the old insolvency tests are no longer the ONLY criteria that decides whether or not a homeowner will have cancellation of debt income tax liability.

Now, homeowners are assured they will not have a cancellation of debt income tax liability when completing a Short Sale (or foreclosure), so long as the property qualifies as their principal residence and the total amount of canceled debt does not exceed $2 million.

For real estate investors, the insolvency exceptions continue to be critical in a challenging real estate market because these individuals many own numerous properties, aside from their primary residence, at risk of foreclosure. Because in many instances the investor is insolvent, they avoid federal tax liability for cancellation of indebtedness.