Tax Consequences of a Real Estate Short Sale in 2013

For many homeowners struggling with underwater mortgages in the aftermath of the housing crash, a short sale is often the best possible solution to their problems.

To put it simply, a short sale is where the homeowner sells his or her property for less than what is owed on it. All the lenders have to be on board and agree with the short sale  before it can be completed. The proceeds of a short sale go directly to the lenders, minus closing-fees and other minor transactions costs. Once the short sale is complete, the borrower is free from any obligations on the property; any outstanding debt (the difference in what was owed on the property and what was realized from the short sale) is forgiven by the lenders.

Short sales are advantageous to both homeowners and banks. Homeowners unable (or unwilling) to make monthly mortgage payments on homes with negative equity can take advantage of a short sale to walk away from their obligations debt free and sometimes have a relatively minor hit on their credit ratings. For a more detailed look into why short sales are preferable to all parties involved, please see my earlier blog on the subject.

One thing every homeowner thinking about doing a short sale must be aware of is the tax consequences. Short sales can affect your taxes in negative or positive ways, depending on your financial situation.

Short sales involve the forgiveness of debt by the lender. Any forgiveness of debt is, as far as the IRS is concerned, considered taxable income.

Here’s a basic example:

Current market value of home is $250,000. The homeowner took out a home equity loan on the house in the height of the housing bubble (when the value was considerably higher) and currently owes the bank $300,000. The bank agrees to a short sale and purchases the house for its current market value of $250,000, writing off the outstanding $50,000 as forgiven debt. The State of California views this forgiven $50,000 as gross taxable income.

$250,000 current house value.

$300,000 loan amount based on previous value when the house was worth considerably more.

$50,000 = Amount forgiven by the bank in a short sale. Remember, THE BANK’S LOSS IS YOUR GAIN, and that is why the IRS views this as taxable income.

Fortunately the State of California has passed the Conformity Act of 2010, a law that offers struggling homeowners from being taxed on the forgiven debt from a short sale. The Conformity Act of 2010 essentially a copy of the federal Mortgage Forgiveness Debt Relief Act, a law that exempts taxpayers from having to report forgiven debt from short sales of their primary residence between 2007 and 2013 as gross income on their tax forms.

In many states, including non-recourse states such as California, second mortgages such as a home-equity-lines-of-credit, popularly known as HELOC, are not covered by the state or federal tax exemption laws. To put it simply, the first loan you took out to purchase your house is covered by the Mortgage Forgiveness Debt Relief Act and the Conformity Act, the second or third home equity loans you took out to buy that speedboat or sports car is not. There have been cases where banks have sued borrowers to recoup HELOC money.

The Federal debt relief Act limits the exempt forgiven debt to $2,000,000 for married people, single people, heads of households, and widows or widowers. Married people filing separately have limits of $1,000,000. California’s Conformity Act covers up to $800,000 (or $400,000 if married filing separately) of mortgage debt forgiven between Jan. 1, 2007 and Dec. 31, 2013, through foreclosure, short sale or some other loan modification. Once, again these only apply to debt used to buy, build or renovate a principal residence – home equity loans taken to purchase speedboats and luxury vacations are not covered.

Keep in mind that these laws are not blanket exemptions, and apply only to homeowners unable to maintain regular monthly payments due to financial hardship or decline in home prices. Also remember that these exemptions are limited to debt forgiven on the taxpayer’s primary residence. Vacation homes and investment properties may not be covered by these specific laws, although there do exist ways to minimize the tax burden from the sales of these as well. Always check with a qualified tax accountant or attorney to find out how and if these laws apply to your own situation.

As part of the fiscal cliff compromise on January of this year, the Mortgage Forgiveness Debt Relief Act has been extended another year till the end of 2013. A California Senate Bill to extend the Conformity Act for the remainder of 2013 has been filed on January 3 and is currently pending review by the State Senate Governance and Finance Committee. (See here for latest updates on the bill.)

Tax Consequences of a Real Estate Short Sale in 2013

For more information on the federal Mortgage Forgiveness Debt Relief Act and Debt Cancellation law please visit: http://www.irs.gov/Individuals/The-Mortgage-Forgiveness-Debt-Relief-Act-and-Debt-Cancellation-

For additional background information on California’s Conformity Act of 2010, please visit: https://www.ftb.ca.gov/aboutFTB/newsroom/Mortgage_Debt_Relief_Law.shtml

If you’re thinking of doing a short sale on your property, please contact either Carlos or Alex at Team Aguilar – your San Diego short sale specialists.