Following is a laetter that I requested from an accountant friend of mine, Dan Alexander. With his permission I am posting it here as a guide to the tax consequences of selling real estate "short".

September 4, 2008

The following information was pulled of the Internal Revenue Service website regarding recent hot spots in the real estate industry. Below you see information on Short Sales and Cancellations of Debt, including the Mortgage Forgiveness Act. The bulk of taxpayers will end up falling into the latter of the two subjects should a dire situation arrive.

Short Sales

A short sale is a contract to sell property you borrowed for delivery to a buyer. At a later date, you either buy substantially identical property and deliver it to the lender or deliver property that you held but did not want to transfer at the time of the sale. Usually, your holding period is the amount of time you actually held the property eventually delivered to the lender to close the short sale. However, your gain when closing a short sale is short term if you (a) held substantially identical property for 1 year or less on the date of the short sale or (b) acquired property substantially identical to the property sold short after the short sale but on or before the date you close the short sale. If you held substantially identical property for more than 1 year on the date of a short sale, any loss realized on the short sale is a long-term capital loss, even if the property used to close the short sale was held 1 year or less.

Exclusion from Income for Certain Cancellation of Debt on Principal Residence

The Mortgage Forgiveness Debt Relief Act of 2007 allows individuals to exclude from gross income a discharge of qualified principal residence indebtedness (defined below). This exclusion applies to discharges made after 2006 and before 2010. Additionally, the basis of the principal residence must be reduced (but not below zero) by the amount excluded from gross income. To claim the exclusion, you must file Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment), with your tax return.

Qualified principal residence indebtedness

This is a mortgage you took out to buy, build, or substantially improve your principal residence. It also must be secured by your principal residence. If the amount of your original mortgage is more than the cost of your principal residence plus the cost of any substantial improvements, only the debt that is not more than the cost of your principal residence plus improvements is qualified principal residence indebtedness. Any debt that is secured by your principal residence you use to refinance qualified principal residence indebtedness is treated as qualified principal residence indebtedness, but only up to the amount of the old mortgage principal just before the refinancing. Any additional debt you used to substantially improve your principal residence is also treated as qualified principal residence indebtedness.

Principal residence

Your principal residence is the home where you ordinarily live most of the time. You can have only one principal residence at any one time.

Amount eligible for the exclusion.

The maximum amount you can treat as qualified principal residence indebtedness in $2 million ($1 million if married filing separately). You cannot exclude from gross income discharge of qualified principal residence indebtedness if the discharge was for services performed for the lender or on account of any other factor not directly related to a decline in the value of your residence or to your financial condition.

Ordering rule

If only a part of a loan is qualified principal residence indebtedness, the exclusion applies only to the extent the amount discharged exceeds the amount of the loan (immediately before the discharge) that is not qualified principal residence indebtedness. For example, assume your principal residence is secured by a debt of $1 million, of which $800,000 is qualified principal residence indebtedness. If your residence is sold for $700,000 and $300,000 of debt is discharged, only $100,000 of the debt discharged may be excluded (the $300,000 that was discharged minus the $200,000 of nonqualified debt).

If you require any further explanation or have any questions regarding these issues please contact Daniel Alexander, accountant at Pignatare & Sagan LLC, 413-746-9465.

I really appreciated Dan writing this for me as I believe it sheds light on the tax issues in a concrete way. I hope readers find it as useful!

Thanks Dan - Nyles

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