It is important for homeowners who are dealing with a distressed property to plan for their long term financial well-being. A huge portion of this planning relies heavily upon their understanding of available options and the respective implications. If a permanent loan modification and saving the home is not a viable option, homeowners need a plan to bow out gracefully and start down the path to financial recovery. With the right professional assistance, financial recovery can happen within a few months and people can be homeowners again within a few short years.
When someone loses a home to foreclosure or decides a short sale is their best option, the bank will lose money. That lost money gets reported to the IRS on forms 1099-A or 1099-C. These are income statements and must be reported as income on the tax return. The good news is that there are several tax provisions that allow someone to exclude or reduce this income from ordinary income tax. This is why tax planning is so crucial for someone facing this decision.
The Mortgage Debt Forgiveness Act is one of the provisions we commonly use to eliminate income tax on those 1099s. Here are some important facts about the Act:
- The MDF Act is not a blank check. It does not cover everyone. If cash was taken out of the property and spent (any or all of that money) on something other than major improvement to the property, this provision does not apply.
- This provision only applies to a Primary Residence. 2nd homes and investment properties do not qualify.
- This provision is set to expire December 31, 2012. If this is the only way of getting around paying income tax on the banks loss, homeowners should have a plan in place to deal with the property sooner rather than later.
If a homeowner does not qualify to use the MDF Act, we may be able to use the Insolvency exclusion. As defined by the IRS, a taxpayer is insolvent when his or her total liabilities exceed his or her total assets. Homeowners will need to prove insolvency immediately before the discharge of debt. That means they need to calculate all of your liabilities and assets before the close escrow in a short sale or prior to a foreclosure sale. Planning for this is very important. Insolvency takes into consideration all existing debt (such as mortgages, auto loans, credit cards & student loans) and all assets (such as home, cars, household items, bank accounts & retirement accounts) at the time of sale. Trying to calculate all of this information months or years down the road is extremely difficult.
After deciding to proceed with a short sale, foreclosure or a loan modification with forgiven debt, a homeowner needs a solid plan in place to be sure they are well protected. This area of tax law is complicated and requires a professional who is well versed in this area. It is absolutely crucial to build a solid plan and get on the road to financial recovery.
If you have questions about this article, please email firstname.lastname@example.org or call us at 951-719-1515.
When a bank loses money, they are cancelling debt, which means they will issue a 1099-C in the amount of their loss. The 1099-C is for Cancellation of Debt (COD) income. This is applicable in a short sale, foreclosure, for a loan modification where principal has been reduced, and a loan settlement when the bank has settled for less than was owed. Loan settlements are becoming much more common on 2nd trust deed mortgages. In some foreclosure cases one might receive a 1099-A and in a rare circumstance a 1099 will not be issued at all. That does not mean you should not report the sale or loss of property to the IRS. A 1099 is an income statement and therefore must be reported as income on your tax return. There are special tax provisions that allow you to exclude that money from ordinary income tax. This is the area of tax law that Financial Accounting Services specializes in dealing with.
Unfortunately, the IRS has publicly stated that these tax provisions (most commonly the Mortgage Debt Forgiveness Act) are being “severely misused and abused.” The IRS and CA State Franchise Tax Board are looking at these returns very closely. We have known this to be the case for well over a year, but here is a public statement from the CA FTB:
The tax return following a short sale or foreclosure is now a much higher risk of audit because the bank’s loss must be reported as income on a personal tax return. Obviously, the goal is to use any and all tax provisions to exclude this income from ordinary income tax and the IRS wants to know why. They want to be sure that these returns are being filed accurately and would like to collect every penny they are entitled to. Bottom line is that there are a percentage of people that will have to pay some taxes on this cancelled debt. The Mortgage Debt Forgiveness Act does not protect everyone. Specifically, cash out refinance loans (where the proceeds were used for anything other than home improvement), 2nd homes and investment property are not covered under The Mortgage Debt Forgiveness Act. A tax return that must include this 1099 income needs to be “bullet proof”. It will be looked at more closely so this is not the year for self-prepared returns or dealing with a tax preparer that is not intricately familiar with this area of tax law.
If you have questions about this topic or are looking to schedule a consultation to learn more about how you might be affected by these rules and regulations, please email email@example.com or call (951) 719-1515.
Just as an ounce of prevention can go a long way, so can getting a qualified tax consultation prior to making the decision to short sale, foreclose, or accepting a loan modification offer. Many struggling homeowners do not understand the enormous tax consequences that accompany these types of “taxable events” and end up being caught off-guard come tax season.
What are some of the most important reasons a homeowner should address any possible tax issues ahead of time? You might not have realized the following that can have a significant impact on a homeowner’s personal finances:
- Recently, the FTB announced that the Mortgage Debt Forgiveness Act has been abused by tax payers and preparers, therefore if you file your return using this provision, you have a high likelihood of an audit by the State of California. This reason alone is a strong enough motivator to seek a reputable real estate tax specialist who can ensure the return is properly filed to stand up to any audit inspection.
- Homeowners often times fail to adjust their W4 form to compensate for the lack of deductions they would normally have for property tax and mortgage interest. Once you cease making the payments on your home, these deductions cease as well. If you do not make adjustments in your current paycheck withholdings, you might find yourself owing a significant amount more to the IRS than you had expected. No one wants that kind of surprise.
Tax consequences that arise from short sale, foreclosure or loan modification need not be taken lightly and shouldn’t be ignored. Proper planning and understanding of what the tax ramifications are is an important part in long term financial recovery. Each homeowner’s circumstances are unique, therefore there are no cookie-cutter solutions. If a homeowner owns multiple properties and investments, the complexities of the law increase dramatically.
If you have already filed your return for the year of the taxable event (i.e. short sale, foreclosure, loan modification) and are unsure of the validity of the return, we recommend you contact us to schedule an appointment to review your situation and determine if there are amendments we can make to ensure your financial well-being is protected.
If you have yet to file your return but have already gone through one (or are about to go through) of these processes, don’t wait until April 2012 to stumble upon a substantial bill from the IRS. Contact us today for an appointment so we can help protect your family and your assets.
For more information or to schedule an appointment, contact Brett Chappell at (951) 719-1515 or via email at firstname.lastname@example.org.
An important consideration with respect to foreclosure and shortsale taxation is whether the debt is “recourse” or “nonrecourse.” In the case of recourse debt, the debtor is personally liable. If the debt is nonrecourse, it is secured only by the property and the debtor is not personally liable for any balance.
You should consult with an attorney or tax professional to determine the status of your mortgage, but in California, mortgages that are used to purchase a residence are nonrecourse, but mortgages resulting from a refinance loan are typically recourse. More specifically, secondary liens from a refinance are considered recourse loans.
When a recourse mortgage is foreclosed, the debt is only satisfied up to the sales price of the property. If the lender forgives the balance of the mortgage, there is cancellation of debt income, which could be taxed as ordinary income. Moreover, if the property was encumbered by a second mortgage obtained through a refinance, recourse applies and the homeowner could be sued for the balance due.
Although Gov. Jerry Brown sign SB 458 into law as of July 15, 2011, the bill does not pertain to foreclosures. Given the fact that the vast majority of distressed homeowners have at some point refinanced their homes, a subordinate lien established with a refinance will be subject to recourse in the event of foreclosure. SB 458 effectively prevents secondary lender recourse in a shortsale, but does not provide this same protection with a foreclosure. Because of this, distressed homeowners should have their mortgage situation fully evaluated prior to opting for foreclosure.
Today there are numerous alternatives to foreclosure and the tax implications of a shortsale may not be anywhere near as significant as one may assume. We invite you to contact our office to become fully educated and understand shortsale tax law prior to making a decision.
Ten facts from the IRS regarding Mortgage Debt Forgiveness and short sale tax consequences:
1. Debt forgiveness is typically considered taxable income. However, the Mortgage Forgiveness Debt Relief Act of 2007 may allow you to exclude up to $2 million of debt forgiven on your principal residence.
2. The limit is reduced to $1 million for married persons filing a separate return.
3. You may exclude debt reduced through a mortgage modification, as well as mortgage debt forgiven in a foreclosure.
4. The debt must have been used to buy, build or substantially improve your principal residence and be secured by that property.
5. Refinanced debt used for substantially improving your principal residence may also qualify for the exclusion.
6. Refinanced debt used for other purposes, for example, to consolidate other debt, does not qualify for the exclusion.
7. The special exclusion is claimed with Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, and attaching it to your federal income tax return for the tax year in which the qualified debt was forgiven.
8. Debt forgiven on second homes, rental property, business property, credit cards or car loans does not qualify for the tax relief provision.
9. If your debt is reduced or eliminated you should receive a year-end statement, Form 1099-C, Cancellation of Debt, from your lender.
10. Examine the Form 1099-C carefully. Notify the lender immediately if there are errors. Pay particular attention to the amount of debt forgiven in Box 2 as well as the value listed for the home in Box 7.
For more information about the Mortgage Forgiveness Debt Relief Act of 2007 and other short sale tax consequences, contact our office at (951) 719-1515 for a free consultation.
Short sale tax implications for distressed home owners improved tremendously this week as Governor Jerry Brown signed Senate Bill 458 into law, effectively eliminating secondary lien holders from going after sellers following a short sale.
Previous legislation, SB 931, protected sellers from a deficiency judgment by a first lien holder after a short sale but did not provide any form of relief against judgments filed by secondary lien holders following a closed sale. This resulted in many sellers being levied with judgments for any amount not paid in full to the secondary lien holder and had obvious and severe credit implications.
Now, with the passing of SB 458, the door has opened for many Californians to avoid the negative short sale tax issues of the past and get on the road to credit and financial recovery faster and without the pending doom of a large judgment. The bill will prohibit the holder of a note from requiring the trustor, mortgagor, or maker of the note to pay any additional compensation, aside from the proceeds of the sale, in exchange for the written consent to the sale.
“This decision is fantastic news for the millions of California home owners who are currently upside down on their mortgage and have both a first and second loan,” stated Financial Accounting Services founder and 2010 Sterling Business Owner of the Year, Frederick Karma.
SB 458 will cover any dwelling of 4 units or less which is sold for a sales price less than the remaining amount of indebtedness.
Please contact Frederick Karma of Financial Accounting Services for more information on the tax implications of a short sale.
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.