The truth of consequences: There can be tax implications from a short sale and foreclosure
The only sure things in life are death and taxes.
And like death, taxes can sometimes sneak up and surprise you. Some homeowners who have faced foreclosure or a short sale might be startled to learn that they may face tax penalties. And many won’t find out that they owe taxes until they open their mail and find a 1099.
“What most owners of residential homes being foreclosed upon or short selling do not realize is how uncertain, complicated and confusing the federal and state income tax rules are that apply to their situation,” says Eliot Kaplan, a partner with Squire Sanders in Phoenix.
So how is it possible that you can lose your home and still owe money?
“Cancellation of debt (COD) is the term tax professionals use to describe the kind of income that arises for tax purposes when debt is cancelled or forgiven for less than its full face or principal amount,” says Kelly C. Mooney, a shareholder with the law firm of Gallagher & Kennedy in Phoenix. “COD income is specifically included in a taxpayer’s gross income … COD income is always treated as ‘ordinary’ income for federal tax purposes, such that the tax rates applicable to ordinary income — which can be as high as 35 percent for individuals — apply to COD income.”
Thankfully, all upside-down homeowners won’t face tax implications. Under the Debt Forgiveness Act of 2007, any debt forgiven on a loan used to purchase a principal residence is not taxable income. But if you took out a second mortgage, you might be in tax trouble.
For federal income tax purposes, a short sale or a foreclosure — whether via a judicial foreclosure or a trustee’s sale — can trigger income tax consequences, depending on whether the debt at issue is “recourse” or “nonrecourse” for federal tax purposes, says Mooney.
If your mortgage is non-recourse, your lender can’t make you pay the loan. The only thing it can do is foreclose and sell your house for payment on the debt. If the borrower defaults, the lender can seize the collateral, but the lender’s recovery is limited to the collateral.
“If the debt was nonrecourse, meaning the lender had no recourse other than to take the home back, the debt forgiveness is not taxable,” says Dale A. Walters, CPA, Keats, Connnelly and Associates in Phoenix. “However, there will be a reportable gain to the homeowner if the sales price of the home is greater than the mortgage. Many states allow you to walk away from your (no-recourse) mortgage because of anti-deficiency statutes that prohibit lenders from seeking judgments.”
States that have anti-deficiency laws are Arizona, Alaska, California, Connecticut, Florida, Idaho, Minnesota, North Carolina, North Dakota, Texas, Utah, and Washington.
Where homeowners get into tax trouble is if they are facing a foreclosure or short sale and they have taken out a second mortgage or line of credit against their home.
“All second mortgages and lines of credit are recourse loans,” Walters says.
With a recourse loan, you’re personally responsible for repaying the bank or mortgage company. If you don’t repay the loan, or default, the bank can sue you for the remaining amount due on your loan if the proceeds from a foreclosure or short sale don’t cover the amount you owe. While mortgages are typically nonrecourse debt, a foreclosure can trigger the loan to become recourse debt at the request of the lending institution.
“The difference between a ‘recourse’ loan or a ‘nonrecourse’ loan under state law is whether the lender has the right to collect the deficiency,” Kaplan says.
And what about the tax implications?
Kaplan explains using this example: A homeowner purchased a residential home in 2007 for $1 million, used $100,000 cash as a downpayment, took out an interest-only recourse loan of $900,000 that was secured by the residential home, and used the home as his or her personal residence. In 2011, when the residential home had a fair market value of $700,000, the owner voluntarily gave back the home to the lender.
“Using the foreclosure and short sale facts above, if the lender decides as part of the foreclosure or the short sale to forgive the deficiency, the owner will have taxable ordinary income equal to the $200,000 deficiency,” Kaplan says.
“Fortunately, until January 1, 2013, the U.S. and Arizona have provided for relief from having to include the lender forgiveness of the $200,000 deficiency described in the above foreclosure or short sale as taxable income,” Kaplan says.
So how do you know if you’re going to face the tax man after a short sale or foreclosure?
“The best way to know is to ask your tax advisor,” says Lawrence Warfield of Warfield & Company, CPAs in Scottsdale. “The tax from some debt forgiveness can be avoided, but the facts and circumstances of each depend on various scenarios and issues.”
Understanding the terms: Foreclosure and Short Sale
Foreclosure: When a lender acquires ownership of the residential home securing its loan either through the owner of the residential home voluntarily transferring the residential home to lender or through the lender exercising its state law foreclosure rights.
Short sale: When the lender permits an owner of a residential home which secures its loan to sell such residential home for less than what is owed to the lender under the loan. Usually, the lender receives all the proceeds from such sale.
5 questions to ask
Here are some helpful questions that you will need to ask you tax professional:
1. Can I avoid paying taxes on the forgiven debt if I was insolvent at the time of the short sale?
2. Do I have to file bankruptcy to be considered insolvent?
3. If you already went through a short sale and paid taxes can you file an amended return and get a refund?
4. Does a IRS Form 982 have to be filed in order to be eligible for tax relief?
5. Am I protected under the Mortgage Forgiveness Debt Relief Act Of 2007?
Mortgage Forgiveness Debt Relief Act (MFDRA)
Generally, the MFDRA lets you exclude from your taxable income most if not all of any cancelled or forgiven debt that might come about because of a foreclosure. There are limits, however:
1. The cancelled debt has to be on your principal residence. The debt can be from a loan that you took out to buy, build or substantially improve your home. It can also be for refinancing the mortgage on your home. Since it applies only to your principal residence, commercial and vacation properties usually don’t qualify.
2. Only debt that’s forgiven in 2007 through 2012 qualifies.
3. If you file a joint tax return with your spouse, you can exclude up to $2 million of forgiven debt from your income. If you’re married and file separately, you can exclude up to $1 million.
4. You have to report the amount of forgiven debt on a special IRS form, and attach it to your tax return.