Taxing of Short Sale 'Phantom Income'- Confusing, Unfair and a Misinterpretation

Real Estate Agent with Keller Williams

A couple shows woory over legal docs they are reading

     Summary: the Washington Department of Revenue (“the Department”) has stated that
    Sellers doing short sales must pay excise tax on the amount of their forgiven debt. As a
    former tax attorney and currently active real estate agent in the State of Washington
    (“Washington”), I oppose this on three grounds-

     (1) It’s a misinterpretation of the applicable Washington Statute.
It’s poorly thought out and will be difficult to apply fairly (including knowing where
            ‘the buck stops’- seller, buyer, lender or escrow company)

     (3) It’s will have a chilling effect on short sales, including sales already in progress

     How & why the issue was raised

    At a recent meeting of the Escrow Association of Washington (“the Association”), a
    speaker from the Washington Department of Revenue stated that ‘forgiven debt’ to a
    seller in a short sale should be included in computing excise tax owed by that seller.

    In response to a further query by the Association, the Department reiterated its position-

    The Department expects excise tax to be withheld and paid to the state upon
    the closing of a real estate transaction, not only upon the sale price, but on the
    amount of debt forgiven by the lender on a short sale.

    While the Department acknowledges that the sale price is rebuttably presumed to be the fair market value, it cites the language of RCW 82.45.030 to claim that the tax is due also on the amount of any mortgage debt unpaid the the seller [bolding is mine]-

RCW 82.45.030 **

"Selling price," "total consideration paid or contracted to be paid," defined.

(1)   As used in this chapter, the term "selling price" means the true and fair value of the property conveyed. If property has been conveyed in an arm's length transaction between unrelated persons for a valuable consideration, a rebuttable presumption exists that the selling price is equal to the total consideration paid or contracted to be paid to the transferor, or to another for the transferor's benefit.

 (3) As used in this section, "total consideration paid or contracted to be paid" includes money or anything of value, paid or delivered or contracted to be paid or delivered in return for the sale, and shall include the amount of any lien, mortgage, contract indebtedness, or other incumbrance, either given to secure the purchase price, or any part thereof, or remaining unpaid on such property at the time of sale.

** Items (2), part of (3) and all of (4) are deemed to be non-material and are omitted here for the sake of space. The full provision can be found on the State of Washington’s website here:

  First, It’s a misinterpretation of the applicable Washington Statuteback to top

I believe that the Department is misconstruing the language of the statute.  it does not appear from a more precise reading that “consideration paid” is intended to include consideration paid by the lender, but rather consideration paid by the buyer. 

The reference in the statute to consideration remaining unpaid after closing was adopted in 1993, probably to deal with some of the 1980’s real estate realities-

Seller often carried back a ‘second’ for the buyer, and many times that second was silent (unrecorded).  Additionally, on installment sales of real property a likely second question was whether the tax applied to only the down payment, or to the full purchase price.

It is apparent that these were in fact additional consideration paid by the buyer, and therefore legitimately to be taxed, rather than consideration paid in effect by the lender, as here.

As additional evidence, look at the excise tax affidavit itself. There is no place on to fill in the amount of forgiven debt as part of the consideration paid by the buyer to the seller. Historically is has not been construed to be part of the consideration paid between buyers and sellers. (Instead it is part of the consideration the lender agrees to take from the parties in order to allow the short sale!)

It seems inconsistent for the Department to claim tax owed on the stated sale price when the net value received by the seller is less than what the buyer pays (in the form of seller paid closing costs), and at the same time say excise tax is due on the forgiven debt which is more than the seller receives.

Second, it’s poorly thought out and will be very difficult to apply fairly (or even apply at all!).   back to top

A huge number of sales would be affected: all those short sales currently taking place due to the credit crisis and falling home prices. In a short sale, the seller has no money for closing costs,  the lender is already accepting less than is owed and is the one paying whatever closing costs do get paid.

Just try explaining  to a bank employee in Florida who is managing 300 short sales simultaneously, when she's already balked at the payment of the excise tax, that there is additional excise tax due on the forgiven debt. [Most states don’t have excise due on the sale of real estate.]

Then there is the poor escrow officer who is supposed to determine the amount of forgiven debt. He  doesn't even know the full payoff amount that would have been due if this were a normal sale. For example, will the taxable amount include all the late fees, attorneys’ fees, etc. that are usually stacked on top of the actual loan balance?

What does the Department say it will do if the escrow officer don't compute it, collect it, and pay it over?  Put a lien on the property after closing, making the Buyer responsible for it! Imagine finding out after closing that there’s a lien on the property they didn’t know about.

Buyers already hate short sales because they usually have to wait 45 to 60 days (or more!) for the bank to decide whether or not they get the property.  Meanwhile the buyer's loan rate could change, they could pass up 3 other homes that they like…then not be able to purchase this one.  And even without this new issue, lenders often come back with a higher price than the buyer and seller had agreed upon in the earnest money agreement.

Additional questions: back to top

·        Does the Department of Revenue charge excise tax in a foreclosure on the amount of debt unpaid? Answer: No

·        What about when the seller gives a deed is given in lieu of foreclosure? Answer: No again

·        Will the department be charging Washington Mutual excise tax on any amount of debt not paid off by the Chase purchase of WAMU's assets? Or will they lien the property acquired by Chase thereby suddenly increasing the price paid by Chase by hundreds of thousands of dollars?

·        Won’t this drive up the foreclosure rate? Answer: If short sales are made untenable, sellers will eventually be forced into foreclosure, with these negative effects:

o       the seller’s credit rating will be worse

o       the buyer may lose out on their ‘dream home’ (or at least have to wait through the foreclosure process)

o       the lender will incur additional thousands of dollars in legal and various holding costs

·        How will the department treat short sales closed prior to this recent pronouncement? Will the title and escrow companies be liable to the sellers or buyers who find out years later of their increased liability? Answer: nobody knows

·        Is it fair for the buyers and sellers who weren't “found out" (because  the escrow companies followed what they believed to be the law) to get more favorable treatment than those who close their short sales from now on? Answer: probably not

Third, it will have a chilling effect on short sales. back to top

Even if the Department’s construction of the consideration paid definition were to be upheld, it is obvious that the current economic times demand a different result.  At all levels of government, these unusual times call for unusual measures.  Vancouver’s firefighters have foregone a pay raise they are entitled to under the law.

Even the Internal Revenue Service has recognized the possible economic dangers in this approach. It has applied at least a temporary rule not to tax as income the debt forgiven on a short sale—which the IRS prior to last year always enforced in the absence of an accompanying bankruptcy.

While we understand the need to apply the law fairly, and we know the state is hurting for money just like everyone else, the Washington Department of Revenue should not and must not continue to insist on additional excise tax due on the “phantom income” of debt forgiveness in a short sale transaction at this time.  back to top

Author Note & Disclaimer: Janine L. Hook is a graduate of Northwestern School of Law, where she also was an Editor of the Law Review. She was a member of both Oregon's and Washington's state Bars. For seven years she was a tax attorney to the IRS District Counsel's Office. Janine became interested in real estate and has been a practicing professional for the last 16 years. She is not currently a member of the Bar and is not an attorney in any state. Nothing contained in her postings or in her advice to her clients is meant to be construed as legal advice. If you need legal advice please consult a practicing attorney in your state.

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Ron Tarvin
Residential, Investment properties, rehab projects, property management, luxury homes, new construction! - Katy, TX
Broker, Katy, Houston, Cypress 77450,77494,77095

Shouldn't the Federal government's program enacted last year be the guidelines to how this is administered?  It's not a problem here in Texas because we don't have these types of taxes (excise and income tax) here but you are right that it will affect how homeowners sell their homes now.  It WILL lead to increased foreclosures.

Jan 12, 2009 12:06 PM #1
Respect Realty LLC
Respect Realty LLC - Milwaukie, OR
Brokers - Oregon / SW Washington Real Estate

Wow, what is Washington thinking? Have they not realized that the federal government pretty much gave up on this idea with primary residences because of the exact reasons you stated. Do they really need to get their hands on so much money of the poor, so they can give to other poor people?

Todd Clark, Helping Families Home -

Jan 13, 2009 03:09 AM #2
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