Short Sale Tax Implications and Complications
Today's question is, what are the tax implications of doing a short sale?
We're going to discuss all of the key elements and everything you need to know about the tax liability on a short sale.
Let's start with some historical perspective and background just to help you get oriented.
When the housing market collapsed, Congress enacted this critically important piece of legislation known as the Mortgage Forgiveness Debt Relief Act. This act provided an automatic exemption from any tax liability arising from forgiven debt income on a qualified principal residence. This helped hundreds of thousands of homeowners avoid a huge tax bill following a foreclosure, short sale, or deed in lieu.
Since 2007, the Mortgage Forgiveness Debt Relief Act has expired three times.
Each of those times, Congress has extended and renewed the act. Most recently, the Act expired in 2014 at the end of the year. Congress has yet to extend the act through 2015. We're all sort of cautiously optimistic and hopeful that Congress will do the right thing and come to their senses and extend the act through 2015 and beyond. Right now, we're still sort of in a holding pattern.
To give you a better understanding of how the act worked, the act was designed to shield homeowners from any tax liability arising from forgiven debt related to a mortgage on a qualified principal residence. There were two key terms that must be satisfied in order for you to claim that exemption as a borrower. First, the home had to be a qualified principal residence, which basically means that you lived there for two out of the last five calendar years. It doesn't matter which two. It doesn't have to be consecutive. It doesn't even have to be the most recent two years, as long as you've lived there for two out of the last five calendar years.
The second element was that the money being forgiven must have been originally used as purchase money.
Or, in the alternative as it relates to a second loan or a HELOC or a junior loan, that money must have been used to either improve the house or renovate it or repair it.
If for example, I took out a HELOC of $30,000 and I used that money to buy a Corvette or a boat or something, then the bank turns around and forgives that debt, I would have a tax liability related to that debt because it wasn't used as purchase money and it wasn't used to repair or improve the home. Those are the two key elements of the Mortgage Forgiveness Debt Relief Act exemption, purchase money and qualified principal residence.
It appears that we now may be living in a post-Mortgage Forgiveness Debt Relief Act world which means that we can no longer rely on that exemption to shield homeowners from tax liability.
We have to look to these alternative methods, alternative means by which we can shield ourselves from any tax liability arising from forgiven debt income on a mortgage. I'm still somewhat hopeful and somewhat cautiously optimistic that Congress is going to do the right thing and extend the act through 2015 and beyond, however I can't rely on a mere hunch or speculation to advise my clients on the tax liability associated with a short sale.
That being said, there is a fall back. There is a saving grace in the event that Congress fails to extend or renew the Mortgage Forgiveness Debt Relief Act, and that saving grace is the insolvency clause of the Internal Revenue Code. What the insolvency clause gives us is the potential for universal tax relief associated with any forgiven debt income, not just related to a mortgage, in the event that the Mortgage Forgiveness Debt Relief Act is not renewed or expired. There is no expiration date on the insolvency clause. It's not going anywhere anytime soon. It's built into our tax code.
What it says basically is that to the extent that a borrower is insolvent, meaning that their debts and liabilities exceed their assets, to the extent that they are insolvent, they will be shielded against any forgiven debt income dollar for dollar up to that insolvency amount. It's basically a two tier calculation. We have to figure out two data points to determine whether or not we can avail ourselves of the insolvency clause to shield and exempt ourselves from any forgiven debt income.
The first calculation is pretty easy actually.
It's how much debt did the bank forgive, what is my forgiven debt income. The bank does the math for you in that respect. They will send you a 1099-C form reflecting the amount of forgiven debt. Basically, it's just the difference between what you owed the bank and the total net proceeds from the sale. Anything left, that shortfall amount, that deficiency balance, assuming that the bank waives it and forgives that debt, that's going to be treated as cancellation of debt income, forgiven debt income. You take that number and you set it aside. That's your forgiven debt income.
In a subsequent calculation, we want to figure out our insolvency.
We know that our insolvency will shield us dollar for dollar against any forgiven debt income up to that insolvency number. How do we determine that? I do it the old fashioned way with a T chart. What I mean by T chart is the letter T, two columns, column A and column B. Column A, that's all of your debts and liabilities. Column B, that's all of your assets. You basically plug in the numbers, and to the extent that your debts and liabilities exceed your assets you are insolvent. You can think of it like your net worth, only your net worth is in the red. It's in the negative.
Or, in the alternative, you can hop online and go to arkcalculators.com and use our insolvency calculator and we'll do the math for you. It's a very user friendly, very intuitive interface there. It can help you calculate your insolvency for the purposes of helping you guesstimate your potential tax liability following a short sale.
It's very important to note here that for the purposes of determining insolvency, the IRS wants a snapshot in time of your financial picture the moment before the debt is forgiven.
It's sort of an instant in time before the act of debt forgiveness. What that means from a practical standpoint is that you're going to be including the mortgage debt as a liability in that liabilities column. It cuts both ways. Conversely, you're also going to be using the value of the house as an asset when factoring your assets, in addition to all of your other debts and liabilities, in addition to all of your other assets. Then, you simply crunch the numbers.
When I say a snapshot in time of your financial picture the moment before the debt is forgiven, what I'm referring to is the day before closing, for example. That's when you would want to do this calculation to get the most accurate snapshot in time of your financial picture of your insolvency to help shield you against that forgiven debt income.
Let's say, for example, your insolvency figure is $120,000. That means that your debts and liabilities exceed your assets by $120,000. We know that that amount will shield you against any forgiven debt income up to that figure. I set that number aside. Then again, in a separate calculation, the bank does the math for you, I get a 1099-C reflecting an amount of debt that's $115,000. Upon first blush, that looks like a pretty hefty tax bill, $115,000 of additional forgiven debt income, yikes.
Not to worry, because in this particular instance, your insolvency figure exceeds the amount of forgiven debt. You have nothing to worry about. You are so insolvent that there's no realistic expectation on the part of the IRS that you should have to pay tax on that forgiven debt income of $115,000. You simply don't have the resources. You can't come up with the resources or the money to pay such a hefty tax bill on such a significant portion of forgiven debt income.
Washington is not a non-recourse state.
The reason this information is so critically important is because I can't tell you how often I get phone calls from misinformed homeowners who mistakenly believe that if they simply walk away from the property, there won't be any tax liability associated with the foreclosure. That simply isn't the case. They tell me, "Lambros, I know my rights, I know that Washington is a non-recourse state and I can walk away from this transaction scot-free."
I'm sorry, but that just simply isn't the case. It's simply not true. Washington is not a non-recourse state. What Washington does is it affords the lender the ability to non-judicially foreclose on its lien. By non-judicially foreclosing on that lien, the lender has effectively given up the right and decided to forego the ability to pursue the borrower for a deficiency balance. That act of non-judicial foreclosure in and of itself constitutes a taxable event resulting in forgiven debt income and possible tax liability.
Remember, in Washington state, the lender can always judicially foreclose thus preserving its right to pursue the borrower for a deficiency balance. By electing or choosing to non-judicially foreclose the bank is choosing to forgive that debt, and that may give rise to a tax liability. In many cases, that tax liability could be even higher because the amount of forgiven debt is greater. More forgiven debt, more cancellation of debt income, means a higher tax bill.
It is so important to understand the finer points of the potential tax implications of doing a short sale versus doing a foreclosure or a deed in lieu.
Because in many cases you might actually be worse off doing a foreclosure than doing a short sale. By doing a short sale, you're putting the property on the market, you're getting the highest and best possible offer which reflects fair market value, thereby potentially reducing your overall tax liability.
Please, before deciding on whether to do a short sale or a foreclosure, consult a tax professional who can give you a better sense of your potential tax implications in each scenario.