FAQ's on Taxes related to Real Estate

Q 9.  What are the tax implications of a short sale?

A A short sale where the lender agrees to reduce some or all of the outstanding debt may give rise to forgiveness of debt income (also called "cancellation of debt" income).  The amount of the debt that the lender agrees to write off is treated as ordinary income.  The taxpayer will generally receive a 1099 tax form from the lender in the amount of the debt reduction. This rule applies whether or not the underlying debt is recourse or nonrecourse.** (See Rev. Rul. 82-202, 1982 - 2 C.B. 35 and Rev. Rul. 91-31, 1991-1 C.B. 19.)

Even though the lender may be taking this action to facilitate the sale by the owner who is under a notice of default and facing a foreclosure, the agreement between the owner and the lender is considered voluntary and treated as a debt reduction. 

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**Although this is the majority opinion on this issue, please note that these rules are complex and there is some disagreement even among tax specialists whether the I.R.S. does, in fact, treat reduction of debt in order to facilitate a short sale on a nonrecourse loan as forgiveness of debt income. 
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In addition, if the owner has owned the property for some time and has refinanced to take out some of the equity, the owner could be subject to capital gains taxation when selling the property as well.  For example, the borrower has a remaining loan on the property when the borrower refinances in order to buy other investment property (or to buy a car, or to take a vacation, etc.) and now owes $300,000 to the lender.  Thus, the taxpayer's adjusted basis may be lower than the outstanding balance on the loan (as in the example below).

The tax calculation would look like step one in calculating a foreclosure sale of recourse debt.

SHORT SALE

Example:

1. The unpaid principal of the loan is $300,000;

2. The sales price (FMV) is $250,000;

3. The taxpayer's adjusted basis in the property is $50,000.

Sales price (FMV $250,000) less taxpayer's adjusted basis ($50,000) results in capital gains for the taxpayer.

Sales Price (FMV)           $250,000
Less  Adjusted Basis    $50,000
Capital Gains                  $200,000

Additionally, the taxpayer would have ordinary income from the lender's write off of any debt, which in this example would be $50,000 (** See the discussion above in this question)

 Loan Balance                $300,000
 Less Sales Price          $250,000
 Ordinary Income            $50,000

TAX EXEMPTIONS

Q 10.  Are there any exemptions from the relief of indebtedness income?

AYes. There are four circumstances where the taxpayer can get relief from taxation on forgiveness of debt income:

(1) The taxpayer is insolvent (the taxpayer's debts exceed their assets as determined under Bankruptcy Code Section 108(d)(3);

(2)  The debt is discharged as part of a bankruptcy proceeding;

(3)  The debt discharged is qualified farm indebtedness; or
 
(4)  The debt discharged is qualified business indebtedness (see 26 U.S.C. §108(c)).
 
Additionally, as this is being written, President Bush has asked for legislation that would amend the tax code so that certain taxpayers involved in short sales would not have income from forgiven indebtedness. The indications are that if this amendment were enacted it would provide relief only to homeowners and not to investors.

Q 11.  Are there any exemptions from the capital gains taxation in a foreclosure, deed in lieu of foreclosure or short sale if the property is a principal residence?

A Yes. If the sale, whether through a foreclosure or deed in lieu or short sale, generates capital gains and if the property was the seller's principal residence, the seller may be able to use the capital gains exclusion of $250,000 if single and $500,000 if filing a joint return. This exclusion does not apply to the ordinary income from debt relief.