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What are the tax implications of a real estate short sale?

When a lender agrees to a short sale and sells a property for less then the outstanding mortgage debt, the amount of the debt that the lender writes off is treated as ordinary income. Despite the fact that the owner is in default or facing foreclosure, this amount is treated as forgiveness of debt, and the taxpayer will typically receive a 1099 for the amount of the cancellation of debt.

The amount of the debt or the ordinary income may or may not be subject to taxation depending on different circumstances.

Under the Mortgage Forgiveness Debt Relief Act of 2007 (H.R. 3648) signed by the President on December 20, 2007, IRS code §108(a)(1)(E), provides that a taxpayer will not be taxed upon cancellation of debt income if the following conditions are met:

  • The property sold in the short sale is the taxpayer's principal residence, as that term is used in IRC §121.
  • The cancellation of debt is Qualified Principal Residence Indebtedness** under IRC Section 163(h)(3)(B).
  • The indebtedness is discharged after January 1, 2007 and before January 1, 2010.
  • Forgiven mortgage debt is limited to $2 million 

The definition of a Qualified Principal Residence Indebtedness is a loan secured by the residence used to acquire, construct or substantially improve the residence. The income relief provided is capped at $1,000,000 in the case of a married person filing a separate return and $2,000,000 for all others. 

Any reduction of indebtedness excluded by IRC §108(a)(1)(E) will be applied to reduce the basis of the taxpayer's principal residence, but not below zero. This could result in a higher amount of capital gains tax owed by the taxpayer.

Finally, this is also important to be aware of.

If the owner has owned the home for many years and refinances their loan to take out equity, the owner could also be subject to capital gains tax when selling the property. An example would be if a borrower has a loan on the property when they refinance in order to buy an investment property (or to buy a car, to take a vacation, consolidate credit card debt, etc.) and now owes $300,000 to the lender.

As a result of this example the taxpayer’s adjusted basis would be lower then the balance on the mortgage debt.

Update: Remember the Mortgage Forgiveness Debt Relief Act of 2007 (H.R. 3648) applies to tax owed to the federal government. You will also need to check with your tax professional about any taxes that may be due to the state you live in.

Update: September 4th, 2008: If you would like to read the entire Mortgage Forgiveness Debt Relief Act of 2007 (H.R. 3648) bill you can view it HERE.

Update: Extension given until January 1st, 2014 with section 202 of American Taxpayer Relief Act of 2012

SHORT SALE Example:

  1. The unpaid balance of mortgage is $600,000;
  2. The sales price is $550,000;
  3. The taxpayer's adjusted basis for this property is $50,000.

Sales price ($550,000) less taxpayer’s adjusted basis ($50,000) results in capital gains for the taxpayer.

Sales Price (FMV) $550,000
Less Adjusted Basis $50,000
Capital Gains $500,000

Using this example below the taxpayer would have ordinary income from the lender’s write off of debt which in this example would result in the amount of $50,000. Keep in mind that the discussion above can result in this taxation not being enforced depending on the new Debt Relief Act of 2007.

Loan Balance $400,000
Less Sales Price $350,000
Ordinary Income $50,000

 

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