Short Sale Tax Liability
Unless you’ve been living under a rock for the last few years, you’ve probably noticed the housing market has gone into the tank. This has resulted in short sales galore, but what about short sale tax liability?
One of the most aggravating things about taxes for most people is the fact the IRS takes the concept of logic, rolls it up in a ball and throws it out the window. In truth, Congress is mostly at fault, but nobody likes them to begin with! So, how does this relate to the current housing situation? It all has to do with the classification of debt.
Debt is something one owes to another person or company, right? When you buy a home, you take out a mortgage. That mortgage is a debt that you must pay to keep the home. When this debt is gone because of financial problems, it is both a positive and a negative. The positive is you don’t have to pay for a mortgage you can’t afford anymore. The negative, of course, is you lose the house.
And here is where the friend government tax folks try to bury you.
In the world of tax, forgiven debt is considered income. Taxable income! If I owe you $300,000 to you and you forgive the debt because I am flat broke, the IRS views this agreement as though I just made $300,000 in income. I suddenly owe $150,000 plus in income taxes as if things weren’t bad enough.
With all the short sales occurring in the housing market, the short sale tax liability of former homeowners was nightmarish. Fortunately, the government took a step back from trying to bleed us all for money and passed the Mortgage Forgiveness Debt Relief Act of 2007. The MFDRA allows you to exclude up to $2 million from income tax on a mortgage short sale or foreclosure if married, and $1 million if not. This applies only to your primary home, not secondary properties such as vacation homes.
As a true blue American homeowner, you undoubtedly refinanced your home over the last few years enough times to give Stephen Hawking a migraine doing the calculations. Yes, I see that Cadillac Escalade. From a tax perspective, this can be problematic. The exclusion provided under the MFDRA only applies to the total amount owed on the original mortgage. You can still claim up to that amount if you refinanced, but not above it. For instance, you took out a $300,000 mortgage on the home when you bought it. Values appreciated, you refinanced and took $100,000 more out of it. You owed $400,000 when you short sold the property. You can exclude only $300,000 from the income tax.
The magic form you need to file with the IRS is Form 982. First, you need to wait for the lender to send you a 1099-C. Make sure the numbers are accurate. There can be tax consequences related to the mortgage forgiven and the fair value of the home. It is complicated, so sit down with a CPA to make sure you are not being worked over by your lender. There are also other ways for getting around the taxable income issue, so paying a quality CPA is really worth the money.