Tax consequences are obviously a key consideration when determining whether doing a short sale is the right move or not. Most taxpayers are aware that debts that are forgiven are generally considered income.
The logic behind this is when you take out a mortgage there is an assumed obligation that you will be paying it back. When money is borrowed, the borrower is not required to include the loan proceeds as income because the borrower has to pay back the loan. When the obligation to pay back the loan is removed, the amount of the proceeds the buyer received becomes reportable as income because there is no longer an obligation to repay.
The most common situations when the cancellation of debt income is NOT included as ordinary income are:
- Qualified principal residence indebtedness: This is the exception created by The Mortgage Debt Relief Act of 2007 and applies to most homeowners who have NOT taken cash out refinances. If you are selling your primary residence as a short sale, this exception generally allows taxpayers to exclude income from the discharge of debt. The debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a short sale or foreclosure, is excluded from income (but the basis in the home must be reduced).
- Bankruptcy: Debts discharged through bankruptcy are not considered taxable income.
- Insolvency: If you are insolvent when the debt is cancelled, some or all of the cancelled debt may not be taxable to you. You are insolvent when your total liabilities exceed the value of your total assets.
- Business Property Exclusion: too complicated to explain here.
- Non-recourse loans: (most purchase money mortgages in California are non-recourse) A non-recourse loan is a loan for which the lenders only remedy in case of default is to repossess the property being financed or used as collateral. In other words the lender is not allowed to pursue you personally in case of a default. Forgiveness of a non-recourse loan resulting from a foreclosure does NOT result in cancellation of debt income. However, it may result in other tax consequences.
One of the things in particular that I feel is extremely important to educate a seller doing a short sale is the tax consequences. There are different sets of rules regarding short sale tax liability depending on whether or not the home was a primary residence or not.
When there is a cancellation of debt, the lender is usually required to report the amount of the canceled debt to you and the IRS on a Form 1099-C, Cancellation of Debt. Eligible home owners also must complete IRS form 982 which must be included with the Federal tax return to claim the mortgage relief.
By all means consult a tax professional that is well versed in form 982. This is not the year for the do-it-yourself tax software, nor the tax preparer that does not specialize in this field.