IRS Code - Taxation of a Real Estate Short Sale

This information on taxation of a real estate short sale is not to be taken as tax advice. It’s is for general reference only and you should consult your tax preparer.

We receive this question almost daily. I will try to simplify this response to make it as easy to understand as possible. On December 20^th, 2007 President Bush signed into law the “Mortgage Debt Relief Act of 2007“. President Bush was quoted saying the following about this new law, “When your home is losing value and your family is under financial stress, the last thing you need is to be hit with higher taxes.  So I’m working with members of both parties to pass a bill that will protect homeowners from having to pay taxes on cancelled mortgage debt.” ─ President George W. Bush, 9/1/2007

Previously, if your home value declined and you sold your home for less then what you owed to the bank the previous tax code would allow the IRS to tax the amount of forgiven debt and treat this amount as income.

Now, based on the new “Mortgage Debt Relief Act of 2007″ the amount of debt that is forgiven is not tax considered additional income and you will not be subject to paying taxes on the forgiven debt. This would apply to any debt discharged on or after January 1^st 2007 which is secured by a primary residence which the debt is incurred in the purchase, construction, or substantial improvement of the primary residence.

This is the bill as it reads on the house.gov website, source is http://www.house.gov/

Permanent exclusion from gross income of discharged home mortgage indebtedness. The bill would amend current law, which requires taxpayers to include discharges of mortgage indebtedness as income and to pay tax on this income. The bill would provide a permanent exclusion for any discharge of indebtedness (on or after January 1, 2007) which is secured by a principal residence and which is incurred in the acquisition, construction, or substantial improvement of the principal residence. Instead of including this amount as income, the basis of the individuals principal residence would be reduced by the amount excluded from income under this bill. This proposal is estimated to cost $1.379 billion over 10 years.

Long-term extension of the deduction for private mortgage insurance. The bill extends the deduction for private mortgage insurance for seven years (through the end of 2014). Current law limits the deduction for private mortgage insurance to payments made prior to the end of 2007. The bill would provide that payments will qualify for this deduction whenever they are paid so long as the contract is entered into after 2006 and before 2015. This proposal is estimated to cost $570 million over the next 10 years.

Modification of the qualification tests for cooperative housing corporations. The bill would modify the requirements for qualifying for the special rules available to cooperative housing corporations. Under current law, a cooperative housing corporation must meet several requirements, including a requirement that 80 percent or more of the cooperative housing corporation is earned from the corporation’s tenant-stockholders. The bill would provide two alternatives to this 80 percent rule (i.e., one based on square footage and another based on cooperative expenditures). These two alternatives will make it easier to qualify as a cooperative housing corporation. This proposal is estimated to cost $22 million over 10 years.

Modification of exclusion of gain on sale of a principal residence. The bill amends the current law exclusion of up to $250,000 ($500,000 if married filing a joint return) of gain realized on the sale or exchange of a principal residence. Under current law, the sale of a home will qualify for this exclusion if the home is a taxpayer’s principal residence for at least two of the five years ending on the sale or exchange. This exclusion applies even if the home was initially purchased as a second home. Under the bill, if a taxpayer moves their principal residence to a second home, the taxpayer will only be able to utilize this exclusion to the extent that it relates to the period of time when the home was first used as a principal residence. The bill grandfathers use before 2008. This proposal is estimated to raise $2.005 billion over 10 years.

The first and most obvious would have to be that you will not have a foreclosure on your credit report. This is a definite plus. An experienced short sale Realtor will be able to help you sell your home and eliminate the debt from a mortgage you may not be able to afford. You need a Realtor that is up for the challenge because there are are many real estate agents that will not even know where to begin because they don’t have experience doing real estate short sales. It’s unfortunate but many Realtors can’t even explain the foreclosure process.

Another benefit of a short sale may be that it will allow you to avoid a bankruptcy. One option that many people consider to give them additional time in the foreclosure process is to file a bankruptcy but this option depends on the state you like in. One misconception of a real estate short sale is that you will have to pay the real estate commissions out of your pocket if you are approved for a short sale. If your property is accepted as a short sale and the deal is able to close, you won’t have to provide closing costs to close the deal. The bank will pay all of the closing costs and Realtor commissions when they approve a short sale. Often they work the agents down on their real estate commissions but this item is not something you will have to pay or worry about. All of the items paid in escrow at closing are factored into the banks expense when they decide to approve a short sale.

If the short sale is approved your Realtor may be able to save you from having a Deficiency Judgment issued against you for the short fall in the amount collected from the short sale and the final balance of the Summary Final Judgment. Many of the states have different laws and guidelines for their foreclosure process so be sure to check what applies in your state. 

Another thing to keep in mind is that congress has recently passed new laws that will eliminate the short sale amount from being taxed as ordinary income. In the past borrowers that completed a short sale would receive a 1099 at the end of the year for the amount of money that the bank took as a loss. Under the Mortgage Forgiveness Debt Relief Act of 2007 (H.R. 3648) homeowners that do a short sale on a primary residence will not have to pay taxes on the short sale amount. This does NOT apply to investment property. This new Mortgage Forgiveness act is only for Primary Residences.

If you have any questions about real estate short sales please feel free to ask. We handle real estate short sales in San Diego County but also know agents in other parts of the country that we may be able to refer to you.