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What Are the Tax Consequences of a Short Sale?

Don’t Find Out After the Short Sale Is Concluded!

 tax consequences of a short sale

The tax consequences of a short sale are usually not the first thing that a realtor wishing to earn a commission off of a property transaction wants to talk to you about. It may be something that anyone assisting you with such a sale never bothers to talk to you about at all.

But there can be serious tax liabilities arising from a sale of your home for less than you owe on the balance of your mortgage note or notes.

How Can a Short Sale Increase Your Tax Bill?

If a house is sold for less than is owed under the terms of the mortgage note that the home secures, there will be a “deficiency” resulting from the sale. That is, the difference between what the house sells for and what you on the balance of your mortgage note or notes. Thus the term “short sale.”

In some short sale deals, the lenders holding or servicing the note may agree to refrain from collecting upon the deficiency (that is, coming after you for it!) as part of the short sale negotiation. (A bad short sale deal involves NO guarantee of protection from collections—and there are many of these out there!) If there is a 2nd or 3rd mortgage on the home, including a home equity line of credit, it is even more vital and more difficult to obtain such guarantees.

However, even if these guaranties are delivered and acted upon properly by the involved banks or lenders or investors, the deficiency debt resulting from the short sale will almost certainly still be “charged off” by the holder of the mortgage note(s). That is, the debt will be reported to the IRS as lost business income by the holder of the debt, and they will gain a tax benefit to their bottom-line as a result. In exchange, you will receive a 1099 for the amount of the charged-off deficiency debt and may be required to pay taxes as if the charged-off debt were personal income that you earned by way of working as a contract employee for that creditor in that year. This is because “charged-off” debt is treated by the IRS as “forgiven debt,” and “forgiven debt” is considered by the IRS to be a form of personal income.

In other words, you will receive a 1099 form from the creditor for the amount of the deficiency that you will have to then pay taxes on, unless you are eligible for forgiveness under the Mortgage Debt Relief Act, or some other definitional insolvency standard.

The Mortgage Debt Relief Act is again set to expire at the end of 2013. Although many realtors or other “short sale specialists” will advertise a quick turn-around on a short sale, many take as long as a year or more to fully negotiate, if the negotiation is successful at all. Will your short sale started today be guaranteed to conclude by 12/31/2013? No one can guarantee that it will.

Furthermore, the Mortgage Debt Relief Act only alleviates taxable liability from the foreclosure or short sale of a first mortgage on a primary residence that you actually live in, or a second mortgage or HELOC on the home that you actually live in if the funds borrowed from the HELOC went entirely toward the purchase of the home or improvement of the home. If you are looking at short-selling a rental property or have a large HELOC or other second mortgage the funds from which were used for other debt consolidation, a vacation, or business funding—you are looking at a tax bill.

There can be additional tax implications beyond this basic charge-off situation as well. For instance, if the real estate involved is a personal residence but not your primary personal residence or if it is commercial real property, there can be capital gain income or “prior depreciation recapture” income that is treated for taxable purposes like personal income.

The amount of “personal income” that is taxable resulting from the loss of real estate can be considerable, often more than a person actually earns in a year from their own, real jobs since so many mortgages were so artificially huge at the height of the real estate bubble and since so many of them were so irresponsibly lent.

The Tax Consequences of Surrender of Real Estate in Bankruptcy: NONE!

Generally speaking, a surrender of underwater or already-foreclosed real estate in the bankruptcy process is a quicker, more cost-effective, and more protective way to walk away from a distressed home without fear of future collections or tax liability than a short sale—and certainly a foreclosure.

One of the primary reasons that bankruptcy is a superior way to let a home go than a short sale, despite is negative reputation, is that there are no tax consequences to the surrender of a home or piece of real property in bankruptcy, particularly not a home that is your primary residence.

When you file for bankruptcy, you are legally insolvent. That being the case, there are no taxable consequences resulting from the discharge of debt or from the surrender of property in bankruptcy. Outside of bankruptcy, there are various possibilities for the arising of taxable consequence to the surrender or short sale of property.

The Tax Consequences of a Short Sale: The Bottom Line

If you are considering a short sale and this is of concern to you, it is essential that you examine the tax-protective option of bankruptcy before committing to short sale deal, regardless of how ardent your real estate broker or realtor is about the benefits of the short sale. The credit report “hit” of a short sale is only arguably better than that of a bankruptcy and maybe not much better at all if you have other non-mortgage-related debt that the short sale will not help you out with at all while the bankruptcy will, to the benefit of the debt-to-income ratio that feeds largely into your FICO credit score.

Additionally, there is also the option of stripping a 2nd or 3rd mortgage in order to decrease a home’s negative equity. The Hilla Law Firm has had more than one client who, having considered a short sale due to a large amount of negative equity, found the home to be well worth hanging onto when advise that, in a Chapter 13 bankruptcy, they could simply decrease that negative equity to manageable proportions by stripping off and getting rid of a second mortgage entirely.

If you are a Michigan resident and would like to explore your options for a Chapter 7 or Chapter 13 bankruptcy with an experienced Michigan bankruptcy attorney, please contact us at (866) 674-2317 or click the button below to schedule a free, initial consultation.

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  1. What Are the Tax Consequences of a Short Sale? | Michigan Bankruptcy Lawyer Says:

    […] Click here to read more about the tax consequences of a short sale on the new Michigan Bankruptcy Blog of Michigan Bankruptcy Attorneys The Hilla Law Firm, PLLC. […]