In order to avoid home foreclosures, which can be complicated and lengthy, banks often engage in term negotiations with borrowers. A
short sale occurs when the mortgage lender (the "mortgagees") agrees to alter the original terms of the loan by lowering the outstanding balance of the debt. Such forgiveness often takes place in cases of a financial deficiency, or when shifts in the real estate market result in a negative net equity on the part of the borrower (the "mortgagor"). In particular, under a short sale the home owner is allowed to sell their home for less than their outstanding debt and give the proceeds to the lender in return for forgiveness of the loan.
Generally, a loan officer at the bank will negotiate new loan terms upon the request of the lender. While the bank is not obligated to negotiate with the lender, there are several advantages for both parties when the loan would otherwise result in a foreclosure. If you are considering a short sale, however, there are a number of tax implications to factor into your decision. Where the parties are able to reach a short sale agreement, the forgiven portion of the loan may still be taxed as income on the part of the borrower. This article aims to provide guidance on the most recent changes in the IRS tax structure as its affects property
short sales.
In general, the IRS tax code specifies that a borrower must file a 1099C
Cancellation of Debt form when the forgiven amount equals or exceeds $600. Traditionally, the IRS has treated this amount as fully taxable income on the part of the borrower. The 2007 Mortgage Forgiveness Debt Relief Act (Public Law 110-142, HR 3648), however, amended the tax laws to allow borrowers negotiating the loan on their primary residence to avoid having to declare this debt as income (limited to debts of $2 million or less.) Importantly, this forgiveness stipulation does not apply to rental properties or other non-primary residences that a lender may hold. Previously, only a personal bankruptcy filing could prevent the forgiven debt from being treated as taxable income. With the Debt Relief Act effectively provides an amendment to the original 1986 Internal Revenue Code which allows selective exclusion of forgiven debt from taxable gross income.
Under the conditions of Form 1099-C, there are special circumstances that may affect whether canceled debt is treated as taxable income. In cases where the borrower declares bankruptcy, the debts are fully discharged although the declaration may have broader adverse effects in terms of other financial and tax obligations. Additionally, under certain circumstances the debt is not taxable if a professional accountant has determined that the value of the debt is greater than the appraised, fair market value of the asset in question.
Farm debt is also treated differently according to the law, which is signified by direct farm debt for those who earn over half their gross income directly from farming. If you are seeking to execute a short sale on a residence other than your primary home, but which served as a secondary residence for you personally during the last five years, the Relief Act also provides a graduated scale of gross income reductions.
Depending on the time you physically lived in the home in question, you may be able to deduct a portion of the forgiven amount. It is important to consult with a professional tax attorney or accountant, however, when considering the implications of the law upon your individual situation.