It is so frustrating. Too often, Realtors are unaware of the tax liabilities arising from the cancellation of debt and fail to advise their clients accordingly.
Consider This Scenario – Your Realtor just spent several stressful weeks helping you, a beleaguered home seller, negotiate a short sale. They have helped you demonstrate to the lender that the home’s price has fallen and that to close the deal with the new buyer, the lender will have to forgive $10,000 of your outstanding mortgage loan not covered by the sale proceeds. But you did it, and now everyone is happy. The buyer gets a home, the lender avoids a messy foreclosure, and as the seller, you walk away with no further financial burdens. Well, not quite.
Whenever real estate is sold, whether in a standard transaction, a short sale or a foreclosure auction, there are potential tax consequences for the seller. In this little scenario, the seller may still owe taxes to Uncle Sam — both in the form of capital gains on the home and on the unpaid portion of the mortgage. Yet, too often, Realtors are unaware of the tax liabilities arising from the cancellation of debt and fail to advise their clients accordingly. Don’t make the mistake of working with an inexperienced Realtor.
In a Nutshell – Here’s How It Works
With a short sale, the lender has three possible ways to handle the deficiency balance, which is the portion of the mortgage debt not covered by the sale of the home. First, the lender can attempt to collect the deficiency balance from the seller after the property has closed. Second, the lender may require the seller to sign an unsecured promissory note for the deficiency balance as a condition of agreeing to the short sale. If the new note is for less than the balance of the original debt, the difference would be considered canceled, or forgiven, debt. Third, the lender may agree to cancel the entire deficiency balance.
On the surface, option three would be seem to be the best alternative for a seller. However, the IRS considers any canceled mortgage debt ordinary income. This means that the amount forgiven is taxed at the same rate — somewhere between 15 percent and 30 percent — as the sellers’ salaries. In addition, because the IRS requires the lender to file a 1099-C form stating the amount of the canceled debt, Uncle Sam will have a record of the exact amount of the debt that was cancelled. A seller will also receive a copy of the 1099-C to use in filing income taxes.
4 Exceptions to the Rule
The IRS does recognize four situations in which cancellation of debt will not result in tax liability for the seller. Call me to discuss the four exceptions to see if they apply to your situation. While I certainly don’t intend to give specific tax advice, you should be informed as to the basic facts about the tax consequences of short sales.
With the current foreclosure crisis in this country, many, including NAR, are working to reverse this law. However, until that time, if you find yourself in this situation, you must be aware of the potential tax issues for a short sale. Do yourself a favor, call me today to discuss your individual situation.
