One of the most frequently asked questions about short sales is will the seller have to pay income or gift taxes on the amount of debt forgiven by the banks. Some sellers who do not retain an attorney never even know that is a possibility until they get a 1099 Form in the mail from their lender at the end of the year.
In 2007 the President and Congress passed the Mortgage Debt Forgiveness Act. Prior to the Act any short seller would be responsible for reporting the forgiven debt as a “gift”. Though a short sale hardly feels like a gift most of the time, the principle behind this tax is that a debt owed and forgiven is a benefit to the seller by the lender and Uncle Sam wants his share of the action.
The Mortgage Debt Relief Act of 2007 generally allows taxpayers to exclude income from the discharge of debt on their principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief.
This provision applies to debt forgiven in calendar years 2007 through 2012. Up to $2 million of forgiven debt is eligible for this exclusion ($1 million if married filing separately). The exclusion does not apply if the discharge is due to services performed for the lender or any other reason not directly related to a decline in the home’s value or the taxpayer’s financial condition.
Second homes do not qualify and those short selling a vacation home will be liable for income or gift taxes on the difference between what is owed and the bank’s proceeds from the sale.
All sellers considering short sale should consult their tax professional after determining if they may or may not be exposed to possible tax liability arising from a short sale. Often those in a position to need to short sell a property will have opportunities to absorb the potential liability.
For more information and some helpful FAQ’s on the subject go to the IRS Website’s page dealing with Mortgage Forgiveness Debt Relief Act and Debt Forgiveness.
For a technical article with real examples I encourage you to read Michael Gray, CPA’s article on the Tax Implications of a Real Estate Short Sale vs. Foreclosure.
Mr. Schroeder is an attorney specializing in assisting short sale buyers and sellers through complex residential real estate transactions. He practices law in New Jersey. You can read more about him and his practice at South Jersey Short Sale Attorney.