More advice about foreclosures

So you have just completed a stressful short sale with the lender accepting less money than they are owed on the property.  A buyer purchased a home, the lender avoided a costly foreclosure process, and the seller walks away without any further financial burdens…or so they think.

There are always tax consequences whenever real estate is sold.  The seller may still owe taxes for capital gains on the home and on the unpaid portion of the mortgage.  This is often overlooked and can be even more costly to the seller down the road.

A lender has 3 possible ways to handle the deficient mortgage balance in a short sale.

1) The lender can attempt to collect the deficient balance from the seller after the property has closed.

2) The lender may require the seller to sign an unsecured promissory note for the deficient funds as a condition of agreeing to the short sale.  If the new note is for less than the balance of the original debt, the difference would be considered forgiven debt.

3) The lender may agree to cancel the entire deficient balance.

Though option 3 seems to be the best for the seller, the IRS considers any canceled mortgage debt to be ordinary income…meaning the amount of forgiven debt is taxed at the same rate as the seller’s salary, usually between 15%-30%.  The IRS requires the lender to file a 1099-C form stating the amount of canceled debt.

There are four situations that the IRS allows which will not result in tax liability for the seller. 

A seller may avoid tax liability when:

1) The borrower receives a bankruptcy discharge and the deficiency was included in the bankruptcy.

2) The borrower is insolvent at the time of the cancellation of the debt.  Insolvency would occur when a borrower’s liabilities exceed assets.  The seller would have to prove this insolvency to the IRS when filing a tax return.

3) The debt was secured by a nonrecourse loan.  Under a nonrecourse loan, the lender does not have the legal right to collect a deficiency judgment from any assets of the debtor not pledged to secure the loan.  While most home mortgages do not fall into this category, purchase loans on a person’s residence are nonrecourse in some states.

4) The tax liability from the cancellation of debt on an investment property can be offset against other business liabilities and expenses.  This exception does not apply to properties occupied as a residence by the mortgagor.

In many short sales, a seller would be able to qualify under the first two of these exemptions, especially since it was almost certainly necessary to show financial hardship in order to convince the lender to agree to a short sale.  However, it is the SELLER’S responsibility to notify the IRS why the amount in the 1099-C should not be counted as ordinary income.  Otherwise, the IRS will consider the forgiven debt as income and penalize the seller for unpaid taxes.

All sellers should seek professional tax advice regarding the possible tax consequences of selling their home. 

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