Income Tax and Short Sales
One of the problems with a “short” sale used to be that a seller had to pay income tax on the amount the payment was “short”. So, if you owed the bank $300,000 and you paid back only $250,000 when the sale closed, the $50,000 that you are short is taxed as ordinary income. That phantom income of about $50,000 could cost you $14,000 to the IRS and more to the state taxing authorities.
The Mortgage Forgiveness Debt Relief Act of 2007 was signed into law eliminating the income tax for some sellers whose sales close between January 1, 2007 and January 1, 2010. There are several requirements:
1. The property sold must be your principal residence, as defined in section 121 of the Internal Revenue Code.
2. The debt that is forgiven must be “Qualified Principal Residence Indebtedness”, i.e. the money used to acquire a principal residence.
3. There is a limit of Two Million Dollars for the amount of non-taxable Debt Forgiveness, a limit that will not affect the vast majority of homeowners.
These rules raise some questions. The biggest one is what is Qualified Principal Residence Indebtedness. The law says “For purposes of this section, the term `qualified principal residence indebtedness’ means acquisition indebtedness . . . with respect to the principal residence of the taxpayer.” So, if you refinanced the house for more than what you owed and took money out to spend on other things, that additional amount is not covered by this law. For example, you had a loan of $200,000 when you bought the house. You refinanced it with a loan of $400,000, and used the additional money to pay off your other debts. If you sell the home and pay $350,000 instead of the $400,000 debt, this new law does not protect you from paying income tax on the $50,000 that was “short”. If you take out a mortgage to buy the house, refinance it for the amount owed on that mortgage (and no more), then your payment to pay off the mortgage is $50,000 short, you will not pay tax on that amount.
Another question is do you need to have lived there for 2 years out of the five years before your home is sold, as that requirement exists to establish a home as your principal residence in order to avoid paying tax on the gain when you sell your primary residence. This question comes from the reference in the law to section 121 of the internal revenue code, which is normally used to eliminate tax on a home where you made up to a $500,000 profit when you sell it. To qualify for that exclusion from tax, you have to live in the house for 2 years out of the five years before you sell it. It does not make sense to impose that requirement based on the purpose and intent of the legislation, but there is a lot of the Internal Revenue Code that does not make sense. For example, this law was designed for people who bought a home with financing and did not pay back that same financing that was used only to buy the home. If someone is forced to live in the home for years before they are excluded from the income tax on a short sale, it defeats the purpose of the legislation. Also, the longer someone lives in a home the more likely it is that there was a “cash out” refinance, and failing to pay back the cash that you got out of the homes is taxable under this new law.
A property that is purely an investment property does not qualify for the exclusion from taxes if you sell it short. But, a property can be rented for a while and still be your principal residence, so it could qualify. Under section 121 of the IRC, if you lived in the home for two years, then rented it for up to three years, then you sold it, it is still your principal residence. So, if you sold it short in this situation, you may qualify for the exclusion. New legislation restricts this provision, so that the time your rent the property decreases the amount of the deduction.
One more question is what happens if you refinance the home and use the additional funds to remodel the home. Normally, that would increase your basis in the home, so it would decrease your tax liability if you sold the house. So, it would be logical to allow this type of refinancing to be subject to the protection of the new law. Again, it is hard to rely on logic when dealing with the IRS, so I hope there are some regulations developed to interpret this situation. The new pamphlet “Tax Relief For Struggling Homeowners” says that the Act “applies only to forgiven or canceled debt used to buy, build or substantially improve your principal residence”, so the term “substantially improve” implies that a refinance where the money goes into remodeling the house would be covered by this Act.
It is possible to qualify for a partial exclusion from tax. If some of the debt that was not paid back was for money used to buy your principal residence, that part is not subject to income tax. So, you buy a home with a mortgage of $200,000, you refinance it for $250,000 and use the other $50,000 to pay off your credit card debts. Then, you sell the home and do not pay back $75,000 of the mortgage. The first $50,000 that is not paid back is subject to income tax. The last $25,000 that is not paid back is not taxable.
The amount of forgiven debt that is not taxed is subtracted from the basis of your next house, so that when you sell it, you have to recognize more gain on that sale. For example, you go short by $75,000 when you sell a home, you buy another one later for $400,000. Your basis is not $400,000, but $325,000 as the $75,000 is subtracted from your basis. So, when you sell it, you will have $75,000 more gain. Remember, there is an exemption from tax for $500,000 of gain for a married couple filing jointly, so this amount of additional gain could be covered by this exemption. Even if it is not, if you make more than $500,000 in gain and have to pay some tax, you should not cry.
It is hard to find the text of the law, but here is a link to how it looked when it passed, so you can click here read it for yourself. http://tinyurl.com/2qdnwj . Also, you can look at the information available with IRS Form 982 that a taxpayer must file even if all of the forgiven debt is covered by the Mortgage Forgiveness Debt Relief Act so that there is no tax due. Another source of information is the instructions for IRS form 1099-c that is filed by the bank to tell the IRS how much debt was forgiven. The seller will receive a copy of form 1099-c by January 31 of the year following the sale that will specify the amount of the debt that has been forgiven.
This law is new enough, and in need of interpretation, that if you find yourself in this situation, you need to consult a tax professional before you sell.
So, for people who bought a home, did not refinance it for more, and sold it for less than they owed, there is no income tax due on the short sale, so long as the payment on the mortgage is less than two million dollars short. This legislation eliminates one of the most miserable parts of a short sale, as it was obnoxious for a homeowner to loose all their equity, have to sell their house, and then get a tax bill.
There are other provisions of the Internal Revenue Code that forgive the income tax that could be due on forgiven debt if the taxpayer is insolvent. The IRS Tax Relief for Struggling Homeowners pamphlet says “Normally, a taxpayer is not required to include forgiven debts in income to the extent that the taxpayer is insolvent. A taxpayer is insolvent when his or her total liabilities exceed his or her total assets.” If the seller wants more information, refer to the instructions for IRS Form 982 that goes in to other ways to exclude forgiven debt.
Do not try to be a tax professional for your sellers. If you are a Realtor, you sell real estate, you do not give tax advice. If the seller wants to know about the tax consequences of a short sale, refer him to this post for general information. When my sellers want specific answers to their individual tax questions, I refer them to Richard deButts of Jewell, deButts & Roberts, PLLC , because he has experience with short sales. Do not hesitate to refer your seller to competent tax advisors, first because they will get quality advice and secondly your errors and omissions insurance probably does not cover any mistakes you might make giving tax advice.
One other practice that will protect you from liability is to put a contingency in the contract similar to “this contract is contingent on Seller’s apporoval of the tax consequences of this sale within 10 days of the execution of this contract. Seller is advised to consult a tax professional.” If you have a contingency in the contract for the seller’s review and approval of the tax consequences, there is conclusive proof that the understanding of the tax consequences is an important part of the contract, as the contingency gives the seller the right to terminate the contract if the owner is unhappy with the tax consequences. A similar method to protect yourself is to advise the owner in writing that they must consult a qualified tax professional and putting hold harmless and indemnity provisions in that document so that if the owner later decides that there is a misunderstanding concerning the tax consequences, you are indemnified (financially protected) by the owner against any liability.
The IRS just published a pamphlet that will explain many of the tax issues in a short sale. Click here to get a copy of it. If the sellers ask you tax questions, one of your simplest ways to answer them is to refer to the pamphlet, and give them a copy with your listing materials as you refer them to a qualified tax professional.
Short sales require a wide variety of talent. You thought a regular sale was interesting. Now, you can have a more complicated sale that raises issues from the nearly impossible to read Internal Revenue Code. Just be careful and you can help our financial crisis by getting distressed homes sold.