TAX RELATED CONSEQUENCESFOR FORECLOSURES AND SHORT SALES

Talk to your tax advisor regarding tax implications when opting for a short sale or foreclosure, and how this impacts your financial state. Here are some things you should know in general.
Short Sales and Forgiven Debt – When a borrower escapes paying a part of what they owe on the mortgage, it is known as forgiven debt. Borrowers can incur income tax liability for this forgiven debt, known as “phantom” income.In a few states, a mortgage lender may be given a deficiency judgment against the borrower equal to the difference in the amount owed on the mortgage and the amount that the home goes for at an auction.As this can put the former homeowner even more into debt resulting in their not being able to recover enough to buy another home, the government has passed new federal legislation which has a temporary 3 year suspension on taxation of debt forgiveness.

Many homeownerscan avoid taxes through one of three ways – Mortgage Forgiveness Debt Relief Act of 2007, insolvency, or the loan is a ‘non-recourse” loan.Every homeowner’s circumstances are unique and you may or may not be subject to taxation based on the situation.

• Mortgage Forgiveness Debt Relief Act – Under the Mortgage Forgiveness Debt Relief Act of 2007, signed by the President on December 20, 2007, IRS code 108(a)(1)(E), says that a taxpayer cannot be taxed upon cancellation of debt income if the following conditions are met:

• The short sale property was the taxpayer’ principal residence.
• The cancellation of debt is Qualified Principal Residence Indebtedness*
• Applicable to debt forgiven in calendar years 2007 – 2012.

*The definition of a Qualified Principal Residence Indebtedness is that the original loan used was to either purchase or build the residence.

• Insolvency – Insolvency can be another alternative for avoiding taxes after a short sale or foreclosure if youaren’t eligible for the Mortgage Forgiveness Debt Relief Act.The term “insolvent” means that the debt is more than the value of your assets. In a situation where your liabilities are more than your assets, you are probably insolvent.

You have to file the IRS Form 982 which is the Reduction of Tax Attributes Due to Discharge of Indebtedness to let the IRS know you are insolvent.Usually, the amount by which you benefit from the discharge of indebtedness is included in your gross income.But under some circumstances described in Section 108, you might be able to exclude the amount of discharge indebtedness from your gross income.Exact instructions are set in Section 108 of the Internal Revenue Code.One of the “conditions” they require is that if you were insolvent prior to the short sale, then you might be able to “exclude” the forgiven indebtedness (the amount the lender forgave on the loan) from being added to your gross income for that year.

• Non-Recourse Loans – A home loan can be “non-recourse” as long as it is the original loan that the property was bought with.After a loan has been refinanced, it is no longer“non-recourse.”A loan is non-recourse when either 1) The loan is a result of seller carry back financing for all or part of the purchase price for any real property; or 2) The loan is made to buy a dwelling for not more than 4 families (1-4 units) given to a mortgage lender to secure payment of a loan which is used to pay all or part of the purchase price of that dwelling occupied entirely or in part by the buyer (Code of Civil Procedure 580b).When a loan is non-recourse, if a borrower does not pay, a lender can foreclose, or take back the collateral, but can’t sue the borrower as being personally liable for the amount.

Short Sales and Property Taxes – Usually, in a short sale, the lender will want to see estimated closing costs on a HUD-1 which includes the any real estate commissions, taxes, title insurance costs, homeowner dues, as well as other associated closing costs.The mortgage lender needs to agreeto the HUD-1 before the transaction is finalized.Primarily, the mortgage lender will shell out the outstanding taxes from the agreed upon purchase price and write off the difference between the agreed sale price less closing costs  and what is owed on the mortgage.

Foreclosure and Deficiency Judgments - A mortgage lender who makes a loss on the sale of a foreclosed propertyhas to report the loss to the IRS.If a home sells for $700,000 at an auction, but the mortgage amount was $750,000, the forced sale of the home as well as the fact that it sold for less than the owed amount means that the homeowner made no profit on the sale of the home.As the owner didn’t profit, no tax is due in this case.All the parties are done with the property, unless the lender decides to sue the owners for a deficiency judgment after foreclosure (which is rare these days). Check the laws in your state, however, since not all states have the same rules regarding deficiency judgments.Ultimately, the owner suffers a loss on the property, start to work on repairing their credit, and resume their life.

Foreclosure or Deed-in-Lieu and Property Taxes – If you want to foreclose and leave your home, do you need to continue to pay property taxes?Most homeowners who owe more money on a house than it is worth ask this question. Many believe that they are personally responsible for unpaid property taxes after a foreclosure. It is important to consult an attorney or tax advisor in this case.

Usually, the law is that the taxes are assessed not against the homeowner, but against the property. Is the owner of the property does not pay taxes, the county tax assessor will put a lien on the property and sell the tax certificate at public auction.Whoever purchases this is then liable to pay the unpaid taxes, so that the county tax assessor is not owed anything. If, in a foreclosure sale, the mortgage lender buys the property, its title is subject to tax liability. When the lender sells a bank owned property (REO), the person who buys it must pay all outstanding taxes to get the title, unless the lender is willing to do so.
However, a lender who is offering a deed in lieu of foreclosure canask that all taxes be paid as part of the transaction.

Capital Gains – Capital gains canbe an issue for an owner who used the property as an investment and thus depreciated the property or who took money out of a property.While a short sale or foreclosure happens because the owner ends up owing more than the property’s worth, they could still be liable for the capital gains.One example of capital gain is when a homeowner has refinanced their loan(s) while owning the house and has taken out that equity.After refinancing the home, the homeowner is now in debt for more than its worth, but the value may still be more than the amount they bought the house for.This could lead to possible “gains” for tax purposes.

In a short sale, the capital gain is calculated by subtracting the adjusted basis in the property from the purchase price. This adjusted basis is usually the purchase price of the homeadded to any capital improvements, minus depreciation (if property is investment property).If the adjusted basis exceeds the sales price, then generally there would be no capital gain or loss.

If someone has owned a property as their main residence for a minimum of two years in a five year period ending on the date of the sale, and there was a capital gain, then the homeowner may subtract up to $250,000 (up to 500,000 for married couples filing joint return) from their income.

Note:This information is for general, educational purposes only. Please talk to a tax professional, or an attorney to discuss your specific circumstances.