Tax Consequences of a "Short Sale" of Real Estate
vs. Foreclosure
April
22, 2010
©
2010 by Michael C. Gray, CPA
Our nation is now seeing the effects
of tightening mortgage credit after a liberal period. With increases in
interest rates for adjustable rate mortgages and the conversion to amortization
of principal for interest-only (or negative amortization) loans, home values
for homes favored by subprime borrowers (and even other homes) are collapsing,
and the debtors are either trying to "walk away" from their homes and
allowing them to be foreclosed or are making "short sales."
A
"short sale" is selling the home for less than the mortgage balance
and trying to get the lender to forgive the unpaid balance. This is a new use
of the term, and is not the definition for this item in the Internal Revenue
Code. In the tax law, a "short sale" is a sale of a borrowed item to
be replaced at a future date, usually a security. The only case that I know
about using the term "short sale" for this type of transaction is a
2008 decision, Stevens v. Commissioner.1 With the explosion of real estate short sales, we will
undoubtedly soon see more cases with them.
A reason for debtors to consider a
"short sale" instead of a foreclosure is to try to protect their
credit history.
How
are foreclosures (and deeds in lieu of foreclosure) taxed?
An important consideration in the
results of a foreclosure (or a deed in lieu of foreclosure) is whether the debt
is "recourse" or "nonrecourse." If the debt is
"recourse," the debtor is personally liable for the debt. If the debt
is "nonrecourse," the debt is only secured by the property, and the
debtor is not personally liable for the balance.
You should consult with an attorney
to determine the status of your mortgage. In California, most mortgages that
are used to purchase a residence are nonrecourse, but mortgages from
refinancing a previous mortgage are usually recourse.
When
a nonrecourse mortgage is foreclosed, the property is treated as being sold for
the balance of the mortgage.2 This is important because the gain from a foreclosure of a
principal residence may be eligible for the $250,000 ($500,000 for
jointly-owned marital property) exclusion.
For example, for foreclosure of a
nonrecourse debt,
Nonrecourse debt
|
$500,000
|
Tax basis (cost to determine tax
gain or loss)
|
300,000
|
Gain
|
$200,000
|
If the holding period requirements
are met and the residence was a principal residence, the above gain would be
tax-free.
(Note: The above example is for
consistency and contrast with the results for recourse debt. Most non-recourse
debt for a residence is purchase-money debt, and would not exceed the tax basis
(purchase price) of the residence. When the residence was a replacement
residence for a principal residence sold before May 7, 1997, the tax basis can
be less than the cost of the residence. Most of the mortgages for residences
acquired in that scenario have probably been refinanced and are now recourse
debt.)
For
recourse debt, the debt is only satisfied up to the fair market value of the
property. There is a sale up to that amount. If the lender forgives the balance
of the mortgage, there is cancellation of debt income, which is taxed as
ordinary income.3 (Regulations § 1.61-12.) (But see tax relief enacted for
certain recourse debt secured by a principal residence, below.)
For example, for foreclosure of a
recourse debt,
Recourse debt
|
$500,000
|
Fair market value
|
450,000
|
Cancellation of debt (ordinary
income)
|
$
50,000
|
(If the cancellation of debt was for
"qualified principal residence indebtedness," it will be excluded
from taxable income. If the taxpayer still owns the home after the cancellation
of debt, the excluded amount will be subtracted from the tax basis of the
residence. See the section on "tax relief," below.)
Fair market value
|
$450,000
|
Tax basis
|
300,000
|
Gain
|
$150,000
|
Again, if the holding period
requirements are met and the residence was a principal residence the above gain
would be tax-free, but the cancellation of debt would generally be taxable as
ordinary income, except for certain "qualified principal residence
indebtedness." See the section on "tax relief," below.
Tax
relief enacted for recourse mortgage on principal residence debt forgiveness.
Congress has passed and President
Bush has approved H.R. 3648, the "Mortgage Forgiveness Debt Relief Act of
2007." The legislation is effective for discharges of indebtedness on or
after January 1, 2007 and before January 1, 2010. The Federal Bailout
Legislation H.R. 1424, passed on October 3, 2008, extended this relief through
December 31, 2012.
Under the new law, a discharge of
"qualified principal residence indebtedness" is excluded from taxable
income. "Qualified principal residence indebtedness" is acquisition
indebtedness secured by the principal residence of a taxpayer as
defined for the deduction of residential mortgage interest, but the limit is
$2,000,000 for the exclusion ($1,000,000 for the mortgage interest deduction)
and $1,000,000 for married persons filing a separate return ($500,000 for the
mortgage interest deduction). Also, the exclusion only applies to a mortgage
secured by the principal residence of the taxpayer.
The
election to exclude the income from discharge of principal residence
indebtedness is made on Form 982 (Re. February 2008), Part I, lines 1.e and 2.
According to IRS Publication 4681, a basis reduction amount is entered at Part
II, like 10.b. only if the taxpayer still owns the residence after the debt
cancellation.4 IRS Publications aren't considered legal authority and I
haven't found any other authority for not making a basis adjustment when the
debt cancellation happens at the same time as a foreclosure or short sale.
The exclusion does not apply if the
discharge relates to providing services to the lender or any other factor not
related to a decline in the value of the residence or the financial condition
of the taxpayer/borrower.
According to IRS Publication 4681,
if the taxpayer continues to own the home after the debt cancellation, the tax
basis of the residence (cost used to determine taxable gain or loss on sale) is
reduced by any amount of discharge of indebtedness excluded from taxable
income, but not below zero. There is no basis adjustment if the debt
cancellation happens with a foreclosure or short sale. There will be two
calculations. (1) Cancellation of debt income eligible for exclusion. (2) Sale
of residence to apply applicable exclusion.
The new exclusion of income for
discharge of acquisition indebtedness for a principal residence takes
precedence over the exclusion relating to insolvency (discussed below), unless
the taxpayer elects otherwise.
For example, if the previous example
for a recourse debt was eligible for the exclusion, here are the tax results:
Recourse debt
|
$500,000
|
Fair market value
|
450,000
|
Cancellation of debt excluded from
taxable income
|
50,000
|
Fair market value
|
$450,000
|
Tax basis
|
300,000
|
Gain
|
$150,000
|
If the holding period requirements
are met, the above gain would qualify for the exclusion ($500,000 married,
joint or $250,000 single) for sale of a principal residence.
(Remember the foreclosure of a
non-recourse mortgage is not a discharge of indebtedness, but a
"sale" of the residence in satisfaction of the mortgage. Therefore,
such a foreclosure won’t qualify for the new exclusion, but may qualify for the
exclusion of gain for sale of a principal residence. Also, since the balance of
acquisition indebtedness is almost always less than the tax basis (cost) of the
residence, it would be highly unusual for there to be a gain from a
foreclosure.)
An "ordering rule" in the
tax law says that the exclusion only applies to as much of the amount discharged
as exceeds the amount of the loan which is not qualified principal residence
indebtedness.5 The IRS explains how to apply the rule at Page 8 of
Publication 4681.
For example, Julie Smith’s residence
was foreclosed in 2008. The fair market value of her home was $200,000. The
balance of her mortgage was $275,000. Julie had used $50,000 from refinancing
her home to pay down her credit card debt, not for home improvements. $50,000
of the debt discharge that is not qualified residence debt would be taxable,
and the remaining $25,000 that is qualified residence debt would be excluded
from taxable income.
Another example, the residence of
John and Mary Taxpayers was foreclosed in 2008. The fair market value of their
home was $1,500,000. The balance of their mortgage, which was all acquisition
indebtedness, was $2,250,000. Since the maximum qualified principal residence
indebtedness is $2,000, 000, $250,000 of the debt was not qualified principal
residence indebtedness. The $250,000 non-qualified debt cancellation would be
taxable income, and the remaining $500,000 that is qualified indebtedness would
be excluded from taxable income.
Amounts that are otherwise taxable
in the above examples could qualify for exclusions under other exceptions, such
as for insolvency or bankruptcy.
California
extends debt cancellation tax relief for homeowners.
California has enacted relief
legislation for cancellation of mortgage debt relating to the acquisition of a
pricnipal residence.
Governor Schwartzenegger signed SB
401 (Wolk), the Conformity Act of 2010, on April 12, 2010, while we tax return
preparers were busy finishing income tax returns and extension forms.
Effective for taxable years 2009 through
2012, the maximum qualified principal residence indebtedness eligible for
relief is $400,000 for taxpayers who file as married or registered domestic
partners filing a separate return and $800,000 for taxpayers who file joint
returns, single persons, head of household and qualifying widow or widower
(other individual taxpayers). The federal limits are $1 million for married
persons filing a separate income tax return or $2 million for other individual
taxpayers.
The debt relief that can be excluded
from taxable income is limited to $250,000 for married or registered domestic
partners filing a separate return and $500,000 for other individual taxpayers.
The federal exclusion is limited to the amount of qualified principal residence
indebtedness.
Note that the amount that can be
excluded from taxable income for California was increased compared to the
amounts that could be excluded for 2007 or 2008, which was $125,000 for married
or registered domestic partners filing a separate return and $250,000 for other
individual taxpayers.
Those taxpayers who now qualify for
relief for 2009 and who filed their 2009 California individual income tax
erturns should file amended returns, Form 540X, including an amended Schedule
CA (540/540NR). When filing Form 540X, write "Mortgage Debt Relief"
in red across the top of page one of Form 540X.
There is no California equivalent
for Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness. use
the Federal form marked "California" at the top.
Remember the tax basis of the
residence is reduced for the excluded gain.
What
happens with a "short sale"?
Short sales are taxed under the same
rules as foreclosures.
Recourse debt cancellation is not
satisfied with the surrender of the property, so any debt not satisfied with
the sale proceeds would be taxable as cancellation of debt income, except for
certain "qualified principal residence indebtedness." See section on
"tax relief" above. (Rev. Rul. 92-99, 1992-2 CB 518. Also see
Treasury Regulations Section 1.1001-2(a)(2).)
Therefore, the tax consequences
would be similar to the "recourse debt" example, above. The buyer and
seller might also have legal concerns about whether the lender would consent to
the transaction and whether (for recourse debt) the lender would in fact
forgive the debt.
For example, for a recourse debt
short sale,
Net sale proceeds
|
$450,000
|
Tax basis
|
300,000
|
Gain
|
$150,000
|
Debt
|
$500,000
|
Pay off using net sale proceeds
|
450,000
|
Cancellation of debt (ordinary
income)
|
$
50,000
|
(If the cancellation of debt was for
"qualified principal residence indebtedness," it will be excluded
from taxable income and be subtracted from the tax basis of the residence. See
the section on "tax relief," above.)
For
non-recourse debt short sales when the seller and buyer require the
cancellation of the debt by the lender as a condition of the sale, the debt
cancellation is included in the sale proceeds, like for a foreclosure.6
Therefore, a "short sale"
can be a viable alternative to a foreclosure for debtors with nonrecourse debt
and who qualify for the exclusion from income of the gain from the sale of a
principal residence.
What
about selling expenses for a recourse mortgage?
For simplicity, I have disregarded
selling expenses in the above discussion. For a short sale, selling expenses
reduce the sales proceeds available to reduce the loan. For a foreclosure or
deed in lieu of foreclosure, selling expenses are added to the debt. (See Jerry
Myers Johnson v. Commissioner, TC Memo 1999-162, affirmed CA-4, 2001-1 USTC
¶ 50,391.) The net result should be similar, assuming the fair market value of
the property equals the selling price for a short sale.
For example, for foreclosure of a
recourse debt,
Recourse mortgage balance
|
$500,000
|
Selling expenses
|
50,000
|
Total debt
|
$550,000
|
Fair market value
|
450,000
|
Cancellation of debt (ordinary
income)
|
$100,000
|
(If the cancellation of debt was for
"qualified principal residence indebtedness," it will be excluded
from taxable income. According to IRS Publication 4681, if the cancellation of
indebtedness happened relating to a short sale, no basis adjustment would be
required. If the taxpayer still owned the hoome after teh debt cancellation,
the exclusion amount would be subtracted from the tax basis of the residence.
See the section on "tax relief," above.)
Fair market value
|
$450,000
|
Tax basis
|
-300,000
|
Selling expenses
|
-50,000
|
Gain
|
$100,000
|
For example, for a recourse debt
short sale,
Sales price
|
$450,000
|
Selling expenses
|
-50,000
|
Tax basis
|
-300,000
|
Gain
|
$100,000
|
Recourse mortgage balance
|
$500,000
|
Pay off using net sale proceeds
($450,000 sales price - $50,000 selling expenses) |
400,000
|
Cancellation of debt (ordinary
income)
|
$100,000
|
(Same caveat for "qualified
principal residence indebtedness" as above.)
Cancellation of debt income may not
be taxable if the debtor is insolvent or has the debt discharged in bankruptcy.7 With recent changes in the federal bankruptcy laws, it is
much harder for individuals to file bankruptcy than before the changes.
What
if the fair market value of the home has dropped after purchase?
Example - Non-recourse
foreclosure/short sale
Mortgage balance
|
$500,000
|
Tax basis
|
700,000
|
Loss
|
-$200,000
|
(The fair market value of the
property is disregarded for a non-recourse mortgage.)
If this is a principal residence,
the loss is a non-deductible personal loss.
Example – Recourse foreclosure/short
sale
Mortgage balance
|
$500,000
|
Fair market value
|
450,000
|
Cancellation of debt income
|
$
50,000
|
(But see the rules for exclusion for
cancellation of "qualified principal residence indebtedness" in the
section on "tax relief," above.)
Fair market value
|
$450,000
|
Tax basis
|
$700,000
|
Loss (for personal residence,
non-deductible)
|
-250,000
|
Senator
Grassley asks IRS to help homeowners with loan forgiveness tax bills.
Senator Chuck Grassley, R-Iowa, who
is the ranking minority member on the Senate Finance Committee, has sent a
letter to the Treasury Department and the Internal Revenue Service asking for
help for homeowners who face big tax bills because of home loan debt
forgiveness on a principal residence. Grassley asked that the IRS accept offers
in compromise to eliminate or reduce the taxes for these transactions.
Grassley reminded the IRS that they
may compromise to promote effective tax administration where compelling public
policy or equity considerations identified by the taxpayer provide a sufficient
basis for compromising the liability.
(Similar requests were ignored when
taxpayers suffered tax disasters relating to stock option transactions during the
stock market crash of 2000 and 2001.)
Considerations
for rental real estate
Owners of rental properties often
have accumulated suspended passive activity losses that can be applied against
the income from a debt cancellation with respect to the rental.
Losses from the sale of
income-producing properties may be deductible as ordinary losses under Internal
Revenue Code Section 1231. (The loss is reported on Form 4797.) The loss may
offset cancellation of debt income. If the property isn’t income producing, the
loss may be a capital loss, limited to capital gains plus $3,000.
Taxpayers other than C corporations
may elect to exclude cancellation of “qualified real property business
indebtedness” from taxable income. (Internal Revenue Code Sections 108(a)(1)(D)
and 108(c).) This is mostly debt incurred to acquire, construct, reconstruct or
substantially improve real property used in a trade or business. (Rental real
estate is not considered to be used in a trade or business.) Refinanced
debt up to the qualifying amount of a previous debt also qualifies. The tax
basis of depreciable real property is reduced for the excluded gain. The amount
excluded is limited to the adjusted basis of depreciable real property before
the discharge.
Exclusions for discharges of debt in
bankruptcy in a title 11 case and up to the amount of insolvency are also
available for cancellations of debt relating to investment real estate.
The tax basis of assets must be
reduced for the excluded gain.
(Thanks to Richard Ogg, EA, who
brought the Briarpark decision to my attention!)
P.S. For more information, watch
Michael Gray's interviews of attorney William Mahan for the Financial Insider Weekly,
"How Mortgage Modifications, Short Sales and
Foreclosures Work" and "Short Sales and Foreclosures - Tax
Consequences." Attorney Michael Malter of Binder
& Malter, LLP also discusses short sales in Michael Gray's interview for Financial
Insider Weekly, “What you should know about bankruptcy for individuals”.
There are also explanations about
foreclosures and cancellation of debt in IRS Publications 523, Selling Your
Home; 552, Taxable and Nontaxable Income; and 544, Sales and Other Dispositions
of Assets at www.irs.gov.
Also see the instructions for Form 982. The IRS also recently issued IRS
Publication 4681, Canceled Debts, Foreclosures, Repossessions and Abandonments.
For
the latest U.S. income tax developments relating to real estate, subscribe to Michael Gray, CPA's Real Estate Tax Letter. There is no charge or obligation to subscribe to this
email newsletter.
IRS Circular 230 Disclosure: As required by U.S. Treasury Regulations, you are hereby
advised that any written tax advice contained on this website was not written
or intended to be used (and cannot be used) by any taxpayer for the purpose of
avoiding penalties that may be imposed under the U.S. Internal Revenue Code.
1 Stevens v. Commissioner, T.C. Summary Opinion
2008-61, June 3, 2008 return
2 G. Hammel, SCt, 41-1 USTC ¶ 9169 return
3 Regulations § 1.61-12 ; return
4 IRS Publication 4681, page 7. return
5 Internal Revenue Code § 108(h)(4) return
6 Briarpark v. Commissioner, 5th Circuit, 99-1 US Tax Cases 99-1 ¶ 50,209, 1/6/1999; T.C. Memo 1997-298, 6/30/1997. Also see Treasury Regulations Section 1.1001-2. ;return
7 Internal Revenue Code Sections 108(a)(1)(A) and 108(a)(1)(B) ;return
2 G. Hammel, SCt, 41-1 USTC ¶ 9169 return
3 Regulations § 1.61-12 ; return
4 IRS Publication 4681, page 7. return
5 Internal Revenue Code § 108(h)(4) return
6 Briarpark v. Commissioner, 5th Circuit, 99-1 US Tax Cases 99-1 ¶ 50,209, 1/6/1999; T.C. Memo 1997-298, 6/30/1997. Also see Treasury Regulations Section 1.1001-2. ;return
7 Internal Revenue Code Sections 108(a)(1)(A) and 108(a)(1)(B) ;return
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