Short Sales: What About Taxes?

Question: But Lee, if I do a short sale with you for my property, won't  I receive a tax bill from the IRS for the forgiven debt by the Lender?

===============================================

Yes, it is true that the seller could have a tax consequence as a result
of the short sale. 

However, the Seller will definitely have a tax consequence as a result

of a foreclosure or deed-in-lieu of foreclosure and the

tax consequence is decidedly worse with a foreclosure

or deed-in-lieu of foreclosure than with a Short Sale. 

Consider this example:

Seller Joe has a mortgage balance of $193,000.
Seller Joe's home is currently worth $185,000.

Option 1: Joe lets the home go to foreclosure or deed-in-lieu of foreclosure.

House sells on the courthouse steps for $103,000.

Lender takes a loss of

$193,000
-103,000
========
$90,000

Lender issues a 1099 to Joe for the $90,000 in "forgiven debt".

IRS imputes the $90,000 to Joe as income - Joe owes taxes of $30,000 due
to his 33% tax bracket, or $15,000 due to his 15% bracket. 


Compare that to 

Option 2: Joe does a Short Sale with Lee  

Lee finds a buyer for the home at $175,000 and presents the short sale
package to the Lender. Lender will accept a 3% commission for Lee and
also for the Buyer's agent.  Lender also agrees to pay the closing
costs for the Buyer. 

At closing:

Lender nets:
=========

$ 175,000                    Purchase Price
  - 10,500                       - Total Commission (6%) 
    - 2,625                       - Closing Costs (1.5% of Purchase Price) 
==========
$161,875


Lender calculates "forgiven debt":

$ 193,000               Mortgage Balance 
- 161,875                Received from Short Sale
========
$  31,125                Debt Forgiven 

IRS tax due:

$10,271.25           If Joe is at a 33% Tax rate

or

$ 4668.75           If Joe is at a 15% Tax rate


so Joe owes taxes of $10,271 due to his 33% tax bracket, or $4,669 due to his 15% bracket.

Short Sale saves Joe     

Footnotes: 

1) Short sale agent Lee will try to get Lender to take the $175,000 paid as a full satisfaction of the debt.  In this case, Joe does not owe any taxes.

2) If the lender will not accept that as full satisfaction, Lee has Joe
file an IRS Form 982 stating that he is destitute and cannot pay the
"forgiven debt". IRS has been known to drop collection activities in
these cases. 

3) Short sale agent approaches the lender and negotiates a 20 year, no
interest unsecured (signature) note in which Joe repays the difference -
in this case $31,125. Again, no taxes are due from Joe. 

4) Our politicians have bills in process to revise the Tax Code to
eliminate this tax on forgiven debt. Since 2 to 4 million households are
affected, it may just pass!  If it does, the problem of tax after the
short sale goes away.

Rationale: If you couldn’t afford to continue your mortgage payments, what makes the IRS think you can now pay taxes on an amount that sometimes exceeds your annual income?   For most, you simply can’t. 

The Mortgage Forgiveness Debt Relief Act of 2007 (H.R. 3648) would eliminate tax on debt forgiveness.  This Act has passed the Ways and Means committee and is awaiting Senate Approval.  The hope is that it will pass the Senate and that the President with approve it quickly.  This will be retroactive and will help anyone who has had purchase money debt forgiven during 2007.  To follow the progress of this very

important tax relief legislation, go to the links below:.

Press Release from Ways and Means Committee:
http://waysandmeans.house.gov/news.asp?formmode=release&id=564

Summary of H.R. 3648 Mortgage Forgiveness Debt Relief Legislation:
http://waysandmeans.house.gov/media/pdf/110/Markup%20Summary4.pdf

You can follow the progress of this Debt Relief Act here:
http://www.govtrack.us/congress/bill.xpd?bill=h110-3648

Remember, we are not attorneys or tax specialists.  As always, seek counsel  from your attorney,  CPA, or tax specialist to

advise you on your specific situation.