Short Sales and Tax Credit: A Homeowner’s Guide
For a good majority of homeowners, a short sale is the most attractive option against foreclosure, especially when other solutions such as loan modification do not work out. But what few are aware of are the short sale credit and tax consequences. Your bank may let you off with a short sale, but as many sellers have learned, the IRS is another story. How does short sale credit affect your taxes? Learn more with this quick homeowner’s guide.
Forgiven debt
In a short sale, the lender agrees to accept less than the amount you owe on the home as payment for your mortgage. Basically, short sale credit involves forgiving part of your debt. And as far as the IRS is concerned, forgiven debt is income - and naturally, they'll subject it to taxes. Few homeowners are aware of this because the bank doesn't always bring it up during short sale credit negotiations. You may want to talk to your short sale attorney or agent to see if you can handle the tax obligations that come with the deal.
The Mortgage Debt Relief Act
In 2007, the government passed a bill called the Mortgage Debt Relief Act. Under this law, debt forgiven in a short sale is exempted from taxes for up to $2 million (married couples filing separately are eligible for $1 million each). The exemption will be in effect from 2007 to 2012. Note that the law only applies for forgiven debt that's related to the homeowner's financial hardship or a decline in property values - it does not work when the discount is given in exchange for services to your lender.
Other protections
The Mortgage Debt Relief Act applies to most homeowners doing a short sale on their principal residence. Besides this, short sale credit exemptions also include the following:
-Bankruptcy: Any debt forgiven through a bankruptcy filing rather than a short sale is not considered income and therefore will not be taxed.
-Insolvency: You are considered insolvent when the fair market value of all your assets is less than your total liabilities. If this is the case at the time your short sale credit was granted, the forgiven debt may not be taxable.
-Farm debt: Debts incurred for farm business purposes are not taxable when forgiven in a short sale credit transaction, as long as the farm accounted for more than 50% of your income for the past three years.
-Non-recourse loans: In a non-recourse loan, a default can only be resolved by repossessing your property or collateral - they cannot personally go after you. If the short sale forgives part or all of the loan, the forgiven amount is exempt from taxes, although there may be other short sale credit tax consequences.
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