Beware the Phantom Tax
As if things weren't bad enough for some poor folks unable to make their mortgage payment. Many distressed homeowners are just now realizing that even if they can get out from under their mortgage by "short sale" they will face an income tax liability on their debt cancellation. What? Read on.
CURRENT NEWS
A popular trend in residential real estate sales tactics is the proposed "short sale". This is a situation where the homeowner offers to sell their house, subject to "short sale" approval by their lender. A "short sale" occurs when the sale price of the home is less than the outstanding mortgage balance and the lender forgives the difference by releasing the seller from the remaining amount owed.
There are many reasons why a homeowner may owe more than their house is worth, including declining market values. And, as you can imagine, "short sale" approval from lenders is not easy to obtain. So in many cases a "short sale" tactic is a long-shot one, at best. But if a "short sale" is approved by your lender beware the phantom tax.
BAD NEWS
Under current Internal Revenue Service regulations an individual will be required to pay income tax on the difference between the "short sale" price of their home and the loan balance; i.e., the amount of cancelled debt. The effect of this rule is that "short sale" home sellers will generate an income tax on "paper profits", income that they do not actually receive.
Here's how it works. Suppose you owe $100,000 on your home mortgage and the best you can sell your house for is $90,000. If your lender will allow a "short sale", and you can find someone to buy your house, you will generate $10,000 in cancelled debt on the transaction, which will be included as ordinary income on your federal Form 1040, Line 21.
Table-1.
1) Amount of debt cancelled (loan balance) | $100,000 |
2) - Less: Fair market value of property (sale price) | - $90,000 |
3) = Equals: Income from cancellation of debt [1-2] | = $10,000 |
4) x Times: Effective tax rate | x 15% |
5) = Equals: Income tax payable [3x4] | = $1,500 |
This calculation applies to simple "short sale" transactions. The tax also applies to foreclosures and repossessions, although there is an additional calculation to determine gain or loss.
There are only a few exceptions to this tax, the most common being bankruptcy. If your property is foreclosed in bankruptcy the foregoing does not apply.
WORSE NEWS
Your lender is REQUIRED to issue you Form 1099-C for the amount of debt cancelled and must also report this amount directly to the IRS. Be aware that if you sell your house in "short sale" during 2007 you WILL receive a 1099-C in January, 2008 for the cancelled debt amount.
GOOD NEWS (MAYBE)
Help may be on the way. On April 17, 2007 H.R. 1876, the "Mortgage Cancellation Relief Act of 2007", was introduced by Rep. Robert Andrews [D-NJ] in the House of Representatives. If passed by Congress and signed by the President this law will create a new exemption for "qualified residential indebtedness". This would relieve taxpayers of the phantom tax on "short sales", foreclosures and repossessions. The bill has been referred to the House Ways and Means Committee. It has strong support from the National Association of Realtors.
If passed, the amendments made by this legislation will apply to discharges of debt AFTER the date of enactment of the Act. Therefore, taxpayers will not be relieved of the phantom tax unless and until the new law is passed. There are no retroactive provisions in the Act.
CONCLUSION
Homeowners contemplating a "short sale" should take into account the tax implications, and also the timing of the transaction relative to pending legislation. See your tax preparer or CPA for specific advice.
Copyright © 2007. No reprints without permission.
Joseph A. Wolf, CPA
Licensed Real Estate Broker
RE/MAX BEYOND 2000 REALTY
6370 York Road
Parma Heights OH 44130
(800) 219-9471
joseph.wolf@remax.net
www.BuyersAgentSaves.com
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Hi Joseph-
This is very good information, especially these days. Did you know that law also applies to credit cards or other forms of debt forgiveness? Seems like just another way to keep the rich "rich" and the poor "poor" in my opinion. I wish they would repeal it all : ) Great post.