Short Sales and Their Lingering Tax Implications

Short sales are the only options for many homeowners, but its tax implications continue to affect the housing market.

There is very little that makes short sellers happy these days. But we recently heard from one who finally at least made peace with his problem.

It took two years, but our correspondent finally closed on the short sale of his home. Early in the short sale process, when a buyer made what seemed like a low offer on the home, the lender told the short seller that he would be responsible for a portion of the deficiency – a portion of the loss that the lender was going to sustain if the lender approved the sale.

The short seller had run a small business consulting company and the Great Recession had destroyed his business. His revenue was down 75 percent. With little income and high housing costs, he made the decision to leave his home and move closer to his relatives in a rural town in the East Coast.  His plan was to rebuild his life, his finances and his credit.

When it came time to make a choice between feeding and educating his family or paying his mortgage, he stopped paying his mortgage lender. His credit score plummeted. Now almost three years after he stopped making payments, his credit history and credit score have suffered the consequences of those financial decisions. His credit score dropped from around 800 to the low 500s.

In the end, he received some help from his mortgage lender when the lender forgave the balance of the debt still owing after the sale of the home. If the lender had not agreed to forgive that debt, his only choice would have been to declare bankruptcy.

With a credit score in the dumps, this home seller can now work to get his financial picture back in order.

With the prior mortgage debt out of the way, this seller’s other great concern was with the IRS. When a lender forgives a debt that you owe, the IRS treats that forgiveness as a gift to the borrower as a taxable gift. We often call it “phantom income” because you don’t have the cash in your pocket, but the IRS adds the amount to your taxable income.

Through December 31, 2012, borrowers selling their primary residences that end up with debt forgiveness from their lenders can simply move on. The IRS will not tax home sellers for the amount of forgiven debt when it comes to the sale of their primary homes. If Congress doesn’t extend this debt forgiveness, it will end in a few short weeks. And, that’s precisely what some Americans want.

We recently received a letter from a listener who took issue with the banks forgiving borrowers their debts on their short sales and foreclosures. He also disapproved of the borrowers not paying taxes on forgiven debt. His belief was that borrowers should be required to pay back their debts and the IRS should treat all forgiveness of debt as income.

When a home seller sells his or her home in a short sale or the lender forecloses on the home, the lender evaluates whether it wants to go after the borrower for the deficiency. In making that determination, the lender will balance the cost of going after the borrower with the probability that the borrower will repay the amount owed.

In a short sale, the lender requests documentation from the short sale lender, including tax returns, bank statements, evidence of income along with other documentation. With this information, the lender can decide whether to release the borrower from the deficiency.

If the lender has decided not to go after the borrower, the next question this listener raises is whether the IRS should have the right to collect money on that release of indebtedness gift. In many instances, if the IRS were to attempt to collect on this forgiven debt, the IRS will end up causing these borrowers to file for bankruptcy and, for many people the bankruptcy court might end up releasing that debt anyway.

It’s a vicious circle. One that will drive more foreclosures, bringing down home prices further, continuing the housing crisis. If the economy continues to improve, then perhaps in another year or two, the debt forgiveness can expire without impacting future home appreciation.


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