Debt forgiven in a Short Sale may be taxed as income in 2013!

As you are probably aware, home prices fell off the proverbial cliff around 2007-2008.  And even though values have been improving in the Denver market over the past year or two, most people are still climbing their way out of the housing market’s “pit of despair”.  Those who bought their home with little down, or who had taken equity out of their home before the bust, may now find themselves owing more on their house than it is currently worth.

This becomes a problem if you now have to sell your home.  If you are “upside-down” in your home when you sell, you will either have to bring money to the closing table to pay your lender back in full- or, if your credit is already shot from late payments or pre-foreclosure, maybe a short sale is a good alternative.  In a short sale, the bank allows the homeowner to sell the home for less than what is owed on it.  The lender(s) either agrees to take the proceeds of the sale and forgives the balance owed, or they may require the seller to pay back a portion, or all, of the remaining balance after the house is sold.

Unfortunately, that is not necessarily the end of the story or the financial consequences for the seller.  Up until 2007, the amount of mortgage debt that was forgiven was taxable as income on your federal tax return.  (Ouch! Seems a bit like kicking you when you are already down)!  The Mortgage Forgiveness Debt Relief Act of 2007, now allows many people to exclude the forgiven debt from their income- but you have to “qualify” for the exclusion. For example, the debt forgiven has to be on your primary residence.  It has to be debt that was used to buy, build or substantially improve your home.  The amount forgiven can be no more than $2M for a couple filing jointly ($1M separately). Other conditions apply.

Now here’s the rub!  As you may suspect, all good things must come to an end.   The Mortgage Forgiveness Debt Relief Act expires at the end of 2012.  That means, if you are trying to sell via short sale, you need to close the sale by the end of the year to take advantage of this tax break.  In 2013, any mortgage debt forgiven will go back to being taxable income on your federal return.

This is just a “heads up”  call on my part.  There may be other ways that you can get relief from the tax burden- it just won’t be under the protection of this Act.  To know for sure, you will need to consult a tax adviser or attorney about your specific circumstances.

For those of you that don’t mind poking around the IRS website, you can get a lot of great information about this issue there. Here is a link to a great summary article:  The IRS has an interactive online tool (the ITA tool) to help you determine whether cancelled debt is taxable.  You can also find more information on their website in Publication 4681- Cancellation of Debts, Foreclosures, Repossession and Abandonments, or have a look at Form 982.

In the best case scenario, if you need to short-sell your home, you already have it on the market, under contract, and have a very responsive lender (and only one of them).  But, even if you don’t manage to get your short sale closed by the end of the year, all is not lost!  A short sale can still be a good alternative in 2013 and beyond.  If you have a financial hardship, you still have a good chance at getting the bank to forgive some or all of your remaining balance.  You would just have to pay the taxes on that amount- but it’s still less than paying the full balance. If you are in a financial bind, paying less is almost always better than paying more.

The consequences and issues surrounding short sales can be pretty complex. Consequences vary, and can depend upon which state you live in, who your lender is, what type of loan you have, and more. This tax relief Act is just one little piece of the story.

If you have any questions regarding short sales, contact me at 720-201-3049.  I would be happy to discuss whether a short sale might work for you!