Someone called me today regarding a client who was afraid to short sale their home because they might owe income taxes as a result. This is a common fear, but one that should NOT worry most people. The reason is because of a law passed in 2007, called The Mortgage Forgiveness Debt Relief Act of 2007.
Background: In a short sale, the lender agrees to release its lien on real property even though the sales price will not fully pay off the debt. Legally, the borrower is still liable for the loan balance after crediting the amount of money the lender received at the sale. This is called a “deficiency.” Often, lenders today will forgive some or all of the deficiency in order to encourage homeowners to find short sale purchasers. This saves the lender a lot of time, trouble, and risk over going through a foreclosure. A different route to avoid foreclosure is called a “deed in lieu [pronounced “lew”] of foreclosure.” The borrower deeds their property over to the lender. The lender often forgives some or all of the deficiency.
The problem comes from the IRS. If you loan me $100, and then tell me I can pay back only $50 as payment in full, then I made a $50 profit on that transaction, didn’t I? If you loan me $100,000 to buy a house, and then tell me that I can sell the house, pay you only $50,000, and you will consider that payment in full, then I’ve made a $50,000 profit, haven’t I? I probably don’t like to think of it this way, because now I have no house and no money, so it doesn’t FEEL like a profit. But, it is.
So, when a bank forgives some or all of the balance due on a loan, that is “profit” to the borrower. The bank will send a 1099 to the IRS to tattle on you that you made a profit! We all know that the IRS wants their “cut” of the profits, and this is what scares many people thinking about a short sale or deed in lieu.
They should not worry. Under the Mortgage Forgiveness Debt Relief Act of 2007, you can have up to $1 million of debt forgiveness ($2 million for married filing joint) for mortgages on your principal residence, and owe NO TAXES! This special law will be in effect through the end of 2012.
You can click HERE for a link to the IRS publication that explains the law. That will link you to IRS Publication 4681. Once there, skip down to the section on Qualified Principal Residence Indebtedness.
What is a Qualified Principal Residence? The Act says it has the same definition as used in Section 121 of the Internal Revenue Code. That is the section that says you can make up to $250,000 profit on sale of your home ($500,000 for married filing joint) and not pay any taxes. HERE is a link to Section 121. The most important parts are:
- A property is your principal residence if you used it as your principal residence for a total of two years during the last five years. The two years doesn’t have to be continuous, as long as the time adds up to two years;
- There are more lenient rules if illness or similar condition prevented you from living in the house for the required two years;
- There are more lenient rules if you were stationed elsewhere because of military, foreign service, or intelligence community service.
The bank will still turn in a 1099. BUT, you will file a simple form with the IRS for that tax year (click HERE for the form) and you will not owe any taxes.
If the debt forgiveness was for real estate that was not your principal residence, you still might not owe any taxes. The rules are much more complicated, but you can read about them in the same Publication 4681 in the link above. The very simple version of THAT rule is: If you were insolvent immediately before the debt relief, and insolvent immediately after the debt relief, you will not owe any taxes.
I hope this helps. People should not be afraid to go through with a short sale. The government wants to ENCOURAGE people to find buyers for a short sale. As a result, it is not going to hit them with a huge tax bill for taking such an action.