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Short Sale - AZ Business Magazine January/February 2012

The Tax Implications From A Short Sale, Foreclosure

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.

Arizona Business Magazine January/February 2012

Business Questions - AZ Business Magazine 2006

The Most Important Questions To Ask When Pondering Whether To Sell Your Business

The Big 8

The most important questions to ask when pondering whether to sell your business

 

Selling Your Business Questions - AZ Business Magazine Oct/Nov 2006Some entrepreneurs spend years developing a solid business—growing, investing and nurturing their enterprise into a successful endeavor. Why then, would less effort be put into plans to sell a business? This may sound strange, but according to financial professionals, it happens all the time. Failing to structure your exit can cost in the form of tax penalties, lower profits and the potential for legal action.

 

There are eight issues to consider before selling your business:

1. Is your company structured to be tax efficient and easily sold? “Many businesses outgrow their initial founding entity,” says Carleen Shilling, a tax partner at Eide Bailly. “Having an entity that’s not tax efficient will cost a business owner substantially when they have to pay taxes on their gains.”

2. Does your business make a favorable presentation? Are your finances clear, complete and accurate? “Poor organization can cause a potential purchaser and advisors to label the business as poorly managed and prompt them to start looking for problems,” notes Michael Walling, vice president of mergers and acquisitions for R.B. Gold & Associates.

3. Have your advisory team evaluate plans to sell your business early on. Walling says business owners should begin planning the sale of their business up to three years before they plan to sell. “This is a major event in your life and your financial team should be on board at the very beginning,” says Shilling. Tax implications, legal obstacles and long-term financial requirements should be planned and executed with authority.

4. Have you considered all the tax consequences involved in the sale of your business? While the price may seem like the most important figure you are dealing with in the sale of your company, another figure that is paramount is the amount you will have after taxes are paid. Failure to factor in tax consequences prior to the sale can be costly and, in many cases, irreversible. One of the most common mistakes business owners make involve company real estate. “You never want to be in a situation where you’ve just sold a real estate property for cash and are then wondering if you can defer any taxes by reinvesting the proceeds into another property,” Shilling adds. “Unfortunately, in a normal sale transaction, once the seller gets the cash, it is too late for tax planning.” To defer taxes, a “like-kind” exchange must be executed in line with IRS codes and done prior to such sales.

5. Who are your potential buyers and what’s your sale price? Business owners should determine their goals for the future and determine the most beneficial sale situation. Grooming a successor, having key managers and raising the profile of your business are key, too. “The ideal situation is to attract a number of potential purchasers and initiate an auction,” Walling adds.

AZ Business Magazine October November 20066. How is your timing? Business owners usually can increase the price if they carefully plan the sale and time it just right. “If the business is expanding at the time of the sale, the owners are likely to get a better price than if the company has reached a plateau or is declining,” Walling says.

7. What will you do with your life after the you sell? Will you retire, start another business or reinvest in other entities? All factors should be considered before you sell. Age and lifestyle are other thinking-points. 8. Be prepared for the emotions involved. “Regardless of your age, selling a business can be more emotional than people realize,” Shilling notes. “It is important to be prepared for this huge decision and know that it isn’t always easy to do.”

www.eidebailly.com
www.rbgold.com

 

Arizona Business Magazine Oct/Nov 2006