What Are The Tax Consequences Of A Short Sale?
As we experience the ongoing fallout from the 2008 financial crisis, some homeowners continue to be in the position that they are unable to afford their mortgage payments and they owe more on their loan than the value of their homes. Facing a foreclosure can be an extremely traumatic experience. One way a homeowner can avoid foreclosure is by pursuing a short sale.
A short sale occurs when a homeowner sells their home for less than the total mortgage balance and the lender agrees to accept a reduced mortgage payoff in exchange for releasing the lien on the property. Obtaining consent from a lender for a short sale is not a forgone conclusion. A short sale must be approved by the lender or servicer, who typically engage the seller in a loss mitigation process in order to obtain permission for the sale. Such a process can be quite cumbersome, requiring the submission of a complete financial package and an appraisal. If the short sale is approved, the sale of the home can proceed. However, it is important to note that the reduced mortgage payoff still has to make sense to the seller to realistically proceed with a sale. To complete a sale, the seller needs to cover the reduced mortgage payoff and any potential additional liens (e.g. second mortgage, judgments, water bill, etc.) on the property. The lender should also agree to forgive any mortgage deficiency (i.e. the difference between the total mortgage debt owed and the final sale price).
If the lender agrees to forgive a mortgage deficiency, there could be significant tax ramifications for the seller. At the conclusion of the short sale, the lender will most likely issue a Form 1099C (Cancellation of Debt) to the seller and the IRS. In the past, Congress has removed the potential tax liability from a short sale. Pursuant to the Mortgage Forgiveness Debt Relief Act of 2007 (H.R. 3648), short sales on certain primary residences that occurred between the years 2007 and 2014 had no tax liability from the forgiven debt. Unfortunately, Congress did not extend this law past 2014 and we do not anticipate them extending it in the foreseeable future.
Although, forgiven debt is typically considered taxable income, there are some circumstances where the seller can avoid tax liability on the forgiven mortgage debt that results from a short sale. The first circumstance depends on whether the seller was legally insolvent at the time of the sale. In order to determine if the insolvency exception applies to them, the seller should consult with a CPA. The second circumstance where potential tax liability on a short sale can be avoided is if a bankruptcy discharge is obtained on the subject mortgage debt.
Provided that they qualify to do so, we typically advise our clients to file bankruptcy before applying for a short sale. Obtaining a bankruptcy discharge enables the seller avoid any personal liability on the mortgage debt, wipes out their other dischargeable debts and helps avoid the potential tax liability from a short sale. The seller hereby receives a more complete fresh financial start than by doing a short sale alone. After the bankruptcy case is complete, it can be beneficial to obtain a short sale to remove the debtor’s name from the deed. As a consequence, this will avoid any possible post-filing liability that can accrue such as: property taxes, water, sewer, maintenance, homeowners’ association fees, potential tort liability, etc.
If you have any questions about short sales, please do not hesitate to contact the Law Offices of David I. Pankin, P.C. at 888-529-9600 or contact us using our home page form. David I. Pankin is a Brooklyn bankruptcy lawyer that has been helping clients with bankruptcy, short sales, foreclosure and other consumer matters for over 20 years. Our team is looking forward to hearing from you.