Are Foreclosures and Short Sales Taxable?

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Are Foreclosures and Short Sales Taxable?

You bet-you they are…but there are some outs available for some homeowners.

Let’s look at a quick overview of tax consequences to the homeowner/borrower if a foreclosure is triggered or a short sale is facilitated and some of the outs.

Capital gains and forgiveness of debt are two types of taxable income that can result from a foreclosure (including a voluntary return of the property known as a deed in-lieu of foreclosure) and short sales. Likely to be the straw that breaks the camel’s back for already financially burdened un-suspecting homeowners. Income from these events is taxed differently depending on different factors including whether there was a foreclosure or a short sale and whether the loan was recourse or nonrecourse. The big whammy can occur if a refinance has taken place since the original purchase. Simply put your basis is the original cost, with some adjustments, not the current amount you owe on the property. Due to the potential complications involved it is highly recommended that you talk with your Accountant or CPA regarding this matter.

If a foreclosure occurs a homeowner can receive “capital gain or loss” as in any other sale of real property. Additionally, the homeowner can receive “forgiveness of debt” income. Whether the owner is subject to taxation on this income may depend on whether the debt is “recourse” or “nonrecourse.” If the debt is a recourse debt, the owner may be deemed to have received taxable income in the amount of debt that is forgiven by the lender. There are insolvency and bankruptcy exceptions to this rule, please talk with your attorney or accountant. If the debt is nonrecourse debt, there is no taxable income from forgiveness of debt, but the owner may still be subject to capital gains taxation. When a lender agrees to reduce the outstanding loan amount by means of a short sale forgiveness of debt income can occur. The amount of the debt that the lender agrees to write off is treated as ordinary income. Even though the lender may be taking this action to facilitate the sale by the owner who is under a notice of default and facing a foreclosure, the agreement between the owner and the lender is considered voluntary and the amount of the loan written off by the lender is treated as forgiveness of debt. The taxpayer will generally receive a 1099 tax form from the lender in the amount of the forgiven debt.This forgiveness of debt may or may not be subject to taxation.

Under the Mortgage Forgiveness Debt Relief Act of 2007 signed by the President on December 20, 2007, Internal Revenue Code was added and provides that a taxpayer will not be taxed upon cancellation of debt income if the following conditions are met:

1. The property sold in the short sale is the taxpayer’s principal residence.

2. The cancellation of debt is Qualified Principal Residence Indebtedness*.

3. The indebtedness is discharged after January 1, 2007 and before January 1, 2013.

*Qualified Principal Residence Indebtedness is a loan secured by the residence used to acquire, construct or substantially improve the residence. The income relief provided is capped at $1,000,000 in the case of a married person filing a separate return and $2,000,000 for all others.

Recently passed California law, conforms California’s Revenue and Tax Code to federal law to a few exceptions.

Update 7-31-2009:

The state of California told the Franchise Tax Board not to tax forgiven mortgage debt through the end of 2008 (with Senate Bill 1055). So what about 2009 and beyond? Two bills to extend the protection through the end of 2012 – Assembly Bill 111 and SB 97 – are parked in Assembly and Senate revenue and tax committees.

More Information: Credit After Foreclosure

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