One of the big fears of distressed homeowners across the country is fear of the tax consequences of selling their homes via short sale. The big question most people in this situation have is will I have to pay taxes on the difference? For example, if you owe $400,000 on your house but it sold via short sale for $300,000, would you be responsible for paying taxes on the difference of the remaining $100,000?
According to law — and the Internal Revenue Service — if a financial entity cancels or forgives a debt you owe, and that debt is $600 or over, the lender is required to provide you (and the IRS) a Form 1099-C, entitled “Cancellation of Debt.” And unless you meet certain exceptions or exclusions, this canceled debt is taxable as ordinary income and must be reported on your Form 1040 when you file your annual income tax return.
This means that if you did owe $400,000 on your house but it sells via short sale for $300,000, the difference of the remaining $100,000 can be taxed a income.
There are a number of exclusions contained in the law. If your debt is included in a Chapter 11 bankruptcy case, this is not considered income to you. If you were insolvent immediately before the cancellation — i.e., your liabilities exceed your assets — you are not required to pay any tax on the debt that was forgiven. But the burden is on you to honestly demonstrate that you are insolvent.
If the debt cancellation involved your principal residence — the home in which you live most of the year, vote and pay taxes on — and if the money you borrowed was used to buy, build or substantially improve that home, you will not have to pay any income tax on the debt that was forgiven by your lender.
This is a departure from the general rule that requires debtors to report all forgiven debt as ordinary income (Section 61(a)(12) of the Internal Revenue Code). Up until the so-called mortgage meltdown, there were only two exceptions referenced above: bankruptcy and insolvency.
However, when thousands of homes across the country began to be foreclosed upon, Congress amended the law. For debts forgiven in calendar years 2007-12, up to $2 million of forgiven debt can be excluded from the obligation to pay income tax ($1 million if married filing separately). Furthermore, the exclusion applies to all years, and not just for one.
This is an interesting loophole in the law. If you own more than one home that is “underwater” — i.e., the mortgage exceeds the fair market value of the house — you can claim the exclusion only for your principal house.
If that house is sold via a short sale, nothing prohibits you from moving into your second home, establishing it as your new principal residence, and so long as your total losses do not exceed the statutory cap of $2 million, you can also sell that house as a short sale and not be required to pay any income tax.
Of course, when dealing with the IRS, it seems nothing is easy. The law does not apply to all forgiven or canceled debt. So your vacation home, your car loan or your credit-card debt that is canceled will not qualify for the exclusion, unless you are insolvent or file for bankruptcy relief.
As mentioned earlier, the debt has to be used to buy, build or substantially improve your home. This is called the “qualified principal residence indebtedness” (QPRI). According to the IRS, “Debt used to refinance qualifying debt is also eligible for the exclusion, but only up to the amount of the old mortgage principal, just before the refinancing.”
For additional information, you can get a good publication online from the IRS. It is entitled “Canceled Debts, Foreclosures, Repossessions, and Abandonments” (Publication 4681, available from www.irs.gov: click on forms and publications). You may also want to obtain Form 1099-C (and the instructions for completing that form, from the same website).