Many “Short Sale” transactions are successfully completed without the aid of an attorney, however I always counsel my clients to seek legal advice from either an asset protection or a bankruptcy attorney.  Forward thinking individuals will understand the importance of mapping out a strategy to insulate themselves properly from potential deficiency judgments.

Guidelines are changing at a rapid pace.  New guidelines from the Department of Treasury could possible change the face of “Short Sales’ in a dramatic way.  It is important to understand the laws of your respective state and how this can affect your “Short Sale” transaction.  In Nevada, we are a recourse state, with the laws affecting individuals in various ways depending on the type of transaction it is…whether it is a “Foreclosure“, “Short Sale“, “First Trust Deed“, or “Second Trust Deed“, it is a minefield to navigate.  Being a Certified Short Sale specialist, I understand how difficult this can be for the individual who is in trouble financially.

A good attorney, who is experienced in this area can structure your assets and protect you, creatively, within the confines of the law.  Understand your rights.  Empower your financial well being.  Get good legal advice prior to making a decision on how to move forward with these types of real estate transactions.

The Law Offices of Gary Fales & Associates is the type of firm that will give you strong direction.  They will work hand in hand with you to plan an exit  strategy that makes sense…an empowering move…

In my last post, I opened by introducing Michael C. Gray and his extremely informative article on the tax ramifications of short vs foreclosures.  I have included another portion of this article where he discusses the Mortgage Debt Relief Act of 2007…and how it will affect you directly.

Tax relief enacted for recourse mortgage on principal residence debt forgiveness.

Congress has passed and President Bush has approved H.R. 3648, the “Mortgage Forgiveness Debt Relief Act of 2007.” The legislation is effective for discharges of indebtedness on or after January 1, 2007 and before January 1, 2010. The Federal Bailout Legislation H.R. 1424, passed on October 3, 2008, extended this relief through December 31, 2012.

Under the new law, a discharge of “qualified principal residence indebtedness” is excluded from taxable income. “Qualified principal residence indebtedness” is acquisition indebtedness secured by the principal residence of a taxpayer as defined for the deduction of residential mortgage interest, but the limit is $2,000,000 for the exclusion ($1,000,000 for the mortgage interest deduction) and $1,000,000 for married persons filing a separate return ($500,000 for the mortgage interest deduction). Also, the exclusion only applies to a mortgage secured by the principal residence of the taxpayer.

The election to exclude the income from discharge of principal residence indebtedness is made on Form 982 (Re. February 2008), Part I, lines 1.e and 2. According to IRS Publication 4681, a basis reduction amount is entered at Part II, like 10.b. only if the taxpayer still owns the residence after the debt cancellation.⁴ IRS Publications aren’t considered legal authority and I haven’t found any other authority for not making a basis adjustment when the debt cancellation happens at the same time as a foreclosure or short sale.

The exclusion does not apply if the discharge relates to providing services to the lender or any other factor not related to a decline in the value of the residence or the financial condition of the taxpayer/borrower.

According to IRS Publication 4681, if the taxpayer continues to own the home after the debt cancellation, the tax basis of the residence (cost used to determine taxable gain or loss on sale) is reduced by any amount of discharge of indebtedness excluded from taxable income, but not below zero. There is no basis adjustment if the debt cancellation happens with a foreclosure or short sale. There will be two calculations. (1) Cancellation of debt income eligible for exclusion. (2) Sale of residence to apply applicable exclusion.

The new exclusion of income for discharge of acquisition indebtedness for a principal residence takes precedence over the exclusion relating to insolvency (discussed below), unless the taxpayer elects otherwise.

For example, if the previous example for a recourse debt was eligible for the exclusion, here are the tax results:

If the holding period requirements are met, the above gain would qualify for the exclusion ($500,000 married, joint or $250,000 single) for sale of a principal residence.

(Remember the foreclosure of a non-recourse mortgage is not a discharge of indebtedness, but a “sale” of the residence in satisfaction of the mortgage. Therefore, such a foreclosure won’t qualify for the new exclusion, but may qualify for the exclusion of gain for sale of a principal residence. Also, since the balance of acquisition indebtedness is almost always less than the tax basis (cost) of the residence, it would be highly unusual for there to be a gain from a foreclosure.)

What happens with a “short sale”?

Short sales are taxed under the same rules as foreclosures.

Recourse debt cancellation is not satisfied with the surrender of the property, so any debt not satisfied with the sale proceeds would be taxable as cancellation of debt income, except for certain “qualified principal residence indebtedness.” See section on “tax relief” above. (Rev. Rul. 92-99, 1992-2 CB 518. Also see Treasury Regulations Section 1.1001-2(a)(2).)

Therefore, the tax consequences would be similar to the “recourse debt” example, above. The buyer and seller might also have legal concerns about whether the lender would consent to the transaction and whether (for recourse debt) the lender would in fact forgive the debt.

For example, for a recourse debt short sale,

(If the cancellation of debt was for “qualified principal residence indebtedness,” it will be excluded from taxable income and be subtracted from the tax basis of the residence. See the section on “tax relief” above.)

For non-recourse debt short sales when the seller and buyer require the cancellation of the debt by the lender as a condition of the sale, the debt cancellation is included in the sale proceeds, like for a foreclosure.⁵

Therefore, a “short sale” can be a viable alternative to a foreclosure for debtors with non-recourse debt and who qualify for the exclusion from income of the gain from the sale of a principal residence.

What about selling expenses for a recourse mortgage?

For simplicity, I have disregarded selling expenses in the above discussion. For a short sale, selling expenses reduce the sales proceeds available to reduce the loan. For a foreclosure or deed in lieu of foreclosure, selling expenses are added to the debt. (See Jerry Myers Johnson v. Commissioner, TC Memo 1999-162, affirmed CA-4, 2001-1 USTC ¶ 50,391.) The net result should be similar, assuming the fair market value of the property equals the selling price for a short sale.

For example, for foreclosure of a recourse debt,

(If the cancellation of debt was for “qualified principal residence indebtedness,” it will be excluded from taxable income. According to IRS Publication 4681, if the cancellation of indebtedness happened relating to a short sale, no basis adjustment would be required. If the taxpayer still owned the home after the debt cancellation, the exclusion amount would be subtracted from the tax basis of the residence. See the section on “tax relief” above.)

For example, for a recourse debt short sale,

(Same caveat for “qualified principal residence indebtedness” as above.)

The information provided by Michael C. Gray is Invaluable and Empowering.  Understanding the Mortgage Debt Relief Act of 2006 is imperative.  when you see the relief involved…this is Empowering!

The following two posts are excerpts of a fantastic article written by Michael C. Gray, CPA, an expert in real estate tax issues.  It is so good that I felt compelled to share it with you in detail.  It outlines very well the tax ramifications of short sales and foreclosures.  The next post will review the Mortgage Debt Relief Act signed into law by President Bush.  This is such a key element with respect to the housing crisis and the personal challenges each of us faces.  I have personally spoken to so many individuals who are confused as to what to do and have no idea about this law protecting them for this income tax.

Our nation is now seeing the effects of tightening mortgage credit after a liberal period. With increases in interest rates for adjustable rate mortgages and the conversion to amortization of principal for interest-only (or negative amortization) loans, home values for homes favored by sub-prime borrowers are collapsing, and the debtors are either trying to “walk away” from their homes and allowing them to be foreclosed or are making “short sales”.

A “short sale” is selling the home for less than the mortgage balance and trying to get the lender to forgive the unpaid balance. This is a new use of the term, and is not the definition for this item in the Internal Revenue Code. In the tax law, a “short sale” is a sale of a borrowed item to be replaced at a future date, usually a security. The only case that I know about using the term “short sale” for this type of transaction is a 2008 decision, Stevens v. Commissioner.¹ With the explosion of real estate short sales, we will undoubtedly soon see more cases with them.

A reason for debtors to consider a “short sale” instead of a foreclosure is to try to protect their credit history.

How are foreclosures (and deeds in lieu of foreclosure) taxed?

An important consideration in the results of a foreclosure (or a deed in lieu of foreclosure) is whether the debt is “recourse” or “non-recourse”. If the debt is “recourse”, the debtor is personally liable for the debt. If the debt is “non-recourse”, the debt is only secured by the property, and the debtor is not personally liable for the balance.

You should consult with an attorney to determine the status of your mortgage. In California, most mortgages that are used to purchase a residence are non-recourse, but mortgages from refinancing a previous mortgage are usually recourse.

When a non-recourse mortgage is foreclosed, the property is treated as being sold for the balance of the mortgage.² (G. Hammel, SCt, 41-1 USTC ¶ 9169.) This is important because the gain from a foreclosure of a principal residence may be eligible for the $250,000 ($500,000 for jointly-owned marital property) exclusion.

For example, for foreclosure of a non-recourse debt,

If the holding period requirements are met and the residence was a principal residence, the above gain would be tax-free.

(Note: The above example is for consistency and contrast with the results for recourse debt. Most non-recourse debt for a residence is purchase-money debt, and would not exceed the tax basis (purchase price) of the residence. When the residence was a replacement residence for a principal residence sold before May 7, 1997, the tax basis can be less than the cost of the residence. Most of the mortgages for residences acquired in that scenario have probably been refinanced and are now recourse debt.)

For recourse debt, the debt is only satisfied up to the fair market value of the property. There is a sale up to that amount. If the lender forgives the balance of the mortgage, there is cancellation of debt income, which is taxed as ordinary income.³ (Regulations § 1.61-12.) (But see tax relief enacted for certain recourse debt secured by a principal residence, below.)

For example, for foreclosure of a recourse debt,

(If the cancellation of debt was for “qualified principal residence indebtedness”, it will be excluded from taxable income. If the taxpayer still owns the home after the cancellation of debt, the excluded amount will be subtracted from the tax basis of the residence. See the section on “tax relief”, below.)

Again, if the holding period requirements are met and the residence was a principal residence the above gain would be tax-free, but the cancellation of debt would generally be taxable as ordinary income, except for certain “qualified principal residence indebtedness.” See the section on “tax relief”…

We will cover that Empowering information in our next post…stay tuned!