Current Tax Update
Because of the large number of homeowners with potential tax bills relating to forgiveness of debt income, the House has proposed new tax rules to lessen the impact for those taxpayers. If passed, the benefits would be retroactive to
In plain English, this means the benefit will be available only to people who lived in the foreclosed homes and only if the debt forgiven was debt used to acquire or improve the home. This means that second home owners and investors don't get the benefit. It also means that many refinanced loans will not qualify.
Let's look at three examples:
John sells the house he lives in for $275,000, net of all fees and charges. John has only one loan on the house and he took it out to purchase the home. He has never refinanced. John's outstanding mortgage at the time of the sale (including unpaid interest and late fees) total $300,000. The bank funds $25,000 as forgiveness of indebtedness. Under the new tax act he will not have any taxable income - the house was his principal residence and all the debt was original acquisition indebtedness.
Ed sells the house he lives in for $275,000, net of all fees and charges. John has two loans totaling $300,000 on the house. The first mortgage for $100,000 was taken out when he bought the house. The second mortgage for $200,000 originated a few year ago when Ed refinanced and used the $200,000 proceeds to start a new business venture that later failed. Only the first loan is original acquisition indebtedness. The bank funds $25,000 as forgiveness of debt. Ed has $25,000 of taxable income. The forgiven debt was not related to the purchase or improvement of the principal residence. If Ed had used the second mortgage to add an addition to his house the loan would be considered acquisition indebtedness and he would not have taxable income.
Sue bought a house for investment purposes. Unfortunately, she has had trouble renting it out but was able to sell it using a short sale. The house sold for $300,000 but the outstanding debt was $350,000. The bank funds the $50,000 difference as forgiveness of indebtedness. The entire $50,000 is ordinary taxable income. The home was not Sue's principal residence.
The new tax act, if passed, is scheduled to apply to all transactions since
The tax act should be great news for owners of principal residences with only acquisition debt. Investors and folks with refinances, where the proceeds were not used for improvements to the residence, are exactly where they were under the old tax rules.
Forgiveness of Debt = Taxable Income
If you've been successful in negotiating your short sale - congratulations! Now you need to deal with taxes.
The main issue is Forgiveness of Debt income. There is a long-standing IRS code section (108(a)) that requires forgiveness of debt to be treated as ordinary taxable income. The bank will send you a Form 1099-C specifying the amount.
The amount of taxable income is the difference between the fair market value of the property and the outstanding debt. In practice, this is the difference between the amount realized from the sale and the amount of outstanding debt (including unpaid interest, late fees and other charges). This can be a very large number.
The Internal Revenue Service web site section dealing with the tax implications of Foreclosures and Short Sales provides good general guidance.
The only exception available to most people is insolvency. If you are still insolvent after the forgiveness of debt, you don't have to report taxable income. The actual reporting is done on IRS Form 982. It's complex and we recommend that you use a tax professional to help you complete the form.
Bankruptcy is a clear indicator of insolvency. We've already discussed bankruptcy in a prior section. Just make sure you have informed your bankruptcy attorney that you will have a tax issue related to forgiveness of indebtedness.
You don't have to be bankrupt to be insolvent. Your debts just need to be more than your assets. Pages 21 and 22 of IRS Publication 908 - Bankruptcy provide good background information.
The actual working definition of insolvency is complex. For example, if immediately prior to the forgiveness of the debt, you had assets of $300,000 and debts of $320,000, you would be insolvent by $20,000. If the bank forgives less than $20,000, you have no taxable income. However, if the bank forgives $30,000 in debt, you will have $10,000 in taxable ordinary income. Your tax professional can assist you in determining the amount of your assets and the extent of your liabilities immediately before the forgiveness of debt. It will be important to have this documented.
Taxes on the Gain on
One of the basic rules of taxes is that "all income is taxable unless specifically excluded". Gain on sale of a taxpayer's principal residence is one of those exclusions. The first $250,000 of gain ($500,000 for married taxpayers) is excluded from taxation if a few basic requirements are met.
Most people in short sale or foreclosure situations will not have to worry about tax on the gain. However, investors, refinancers and sellers of second homes may have problems.
"But wait!" you say. "How can I owe tax if I didn't get any cash out in the short sale or the foreclosure?" Yes, you can still have a taxable gain even if you don't get any cash.
Let’s take a look at what constitutes proceeds and basis. The proceeds of a sale include the amount of debt paid off by the bank. Basis only includes the amount paid to acquire or improve the property and is reduced by the amount of debt forgiven.
Bill bought his principal residence years ago for $200,000 and has paid down the mortgage to $50,000. House prices in the area increased greatly and over the years he borrowed an additional $450,000 against the house to pay for trips and medical expenses. The total amount of debt equals $500,000. Bill loses his job and is forced to sell at a price of $450,000. The Bank pays the $50,000 shortfall and forgives the debt. (We'll ignore the possible tax on forgiveness of debt income.) The proceeds from the sale are $500,000 - the purchase price plus the amount of forgiveness of debt. But Bill's basis is now only $150,000. The $50,000 forgiveness of debt reduced his original acquisition cost to $150,000. Bill has a gain of $350,000. Bill is taxed on $100,000 - the $300,000 gain less the $250,000 exclusion.
Adjustments to basis are complex and subject to tricky ordering rules. If you are an investor, a second home seller or someone with a significant amount of refinanced debt you should consult with a tax professional about your potential tax liability.
