TAX LIABILITY Possible with Many Short Sales!

The concept of "Selling Short" in Real Estate merely involves netting less from the sale than the outstanding mortgage balance, or, in some cases, balances - PLURAL!

For some, however, certain home sales proceeds, as well as any debt forgiven by the seller's lender, may be subject to Federal and State Income Tax.

Tax Columnist Bill Bischoff, in the Wall Street Journal today, provides the example of a homeowner who enjoyed some solid appreciation on his home, but ate up that equity with Lines of Credit that brought his total mortgage balance to $50,000 over than what he ended up selling his home for.  Despite the fact that he sold his property for considerably less than his mortgage balance was, the seller still had a tax liability for the gain on the sale.

In Bischoff's example, the seller sold his originally-priced $200,000 house for $300,000, and was saddled with a $100,000 gain, despite having to short pay a total mortgage indebtedness of $350,000.

There is a bit of good news if the property sold was the seller's principal residence, however!  U.S. Tax laws exclude up to $250,000 of home price gain for individuals ($500,000 for married couples filing jointly), so long as you lived in the sold house as your primary residence for two out of the five years prior to the sale.    In this example, the seller would owe no tax on his gain.

Sell the property at a loss?  In other words, if you were forced to sell a $400,000 property for $300,000, you would have a loss of $100,000.  Further, if the outstanding mortgages totaled $350,000, the sale would still be short.

But the loss-on-sale, unless the sold property is an investment - not a principal residence - is not deductible on your U.S. or most state income tax returns.

So what if the lender forgives you for the $50,000 debt your short?  Off the hook?

NO - according to the IRS!

Forgiven Debt is classified as Debt-Discharge Income (DDI), and must be reported by the lender on IRS Form 1099-C as taxable income.

For many, however, DDI is not subject to tax.  If the DDI from mortgage debt was originally taken to acquire, build, or improve upon the borrower's principal residence, up to $2 Million of it is tax-free.  Note that this tax exemption will not apply to those who ran up their Home Equity Line of Credit for other purposes - a new boat, second home, vacation, or payment of college tuition.

If the borrower is in the midst of a bankruptcy filing, or is insolvent, where debt exceeds assets, the DDI is likely not subject to tax.  Also, if the Debt-Discharge Income consists partially of unpaid mortgage interest added to the loan principal balance before being forgiven, the interest portion of the debt forgiveness is tax-free.

If the borrower used seller financing to acquire his property, the DDI created during debt forgiveness  is tax free, but the tax basis of the property, and its potential gain, is reduced by the forgiven amount.

See Bischoff's article for additional examples and calculations.

Please read our post today via BlogChicagoHomes.com.

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