Short Sale Tax Issues

Posted by on Aug 9, 2011 in Articles, Memos | Comments Off on Short Sale Tax Issues

 

Galvin Realty Law Group, P.S.

 

MEMORANDUM

 

 

 Tax Consequences of Short Sales

 

Short sales are taxed under the same rules as foreclosures (and deeds in lieu of foreclosures).  In determining the tax consequences of short sales (and foreclosures and deeds in lieu of foreclosures), the initial consideration is whether the debt is recourse or non-recourse.

 

“Non-Recourse Debt” means that the debtor is not personally liable for the debt and that the debt is therefore secured only by the property.  Thus, if the debt is non-recourse, the short sale purchase price is treated as satisfying the debt and the seller receives no income as a result of the short sale.

 

“Recourse Debt” means that the debtor is personally liable for the debt.  Thus, if the debt is recourse, the seller will receive a monetary benefit as a result of the short sale in the amount of the difference between the short sale purchase price and the balance of the mortgage.  This benefit is referred to as cancelled debt income and is taxable as ordinary income.

 

For example:

Recourse Mortgage Balance:                          $600,000

Sales Price of the Residence:                          $500,000

Selling Expenses:                                            $40,000

Net Sale Proceeds:                                          $460,000

Cancelled Debt Income:                                 $140,000

 

There are several exclusions from the general rule of inclusion of cancelled debt income: (1) bankruptcy; (2) insolvency and (3) qualified principal residence indebtedness.  Cancelled debt income discharged in a title 11 bankruptcy case is not included in income.  Cancelled debt income is also not included in ordinary income to the extent that the debtor was insolvent immediately prior to the cancellation.

 

Cancelled debt income may also be excluded under the Mortgage Forgiveness Debt Relief Act of 2007 to the extent that it is “qualified principal residence indebtedness” (QPRI).  QPRI is any debt incurred in acquiring, constructing, or substantially improving a principal residence and which is secured by the principal residence.  If only a part of the loan is QPRI, the exclusion from income for QPRI applies only to the extent that the amount cancelled exceeds the amount of the loan (immediately prior to cancellation) that is not QPRI.

 

For example:

 

Assume the principal residence is secured by a total debt of $1 million and assume the cost of the property (plus improvements) was $800,000.  Only the debt that is not more than the cost of the principal residence is “qualified principal residence indebtedness.”  So, there is $800,000 in qualified principal indebtedness.  If the property is then sold for $600,000 and $400,000 of debt is discharged, only $200,000 of the debt discharged may be excluded ($400,000 that was discharged minus the $200,000 of non-qualified debt).  The seller will thus pay tax on $200,000 of cancelled debt income.

 

As you work through these issues, please keep in mind that this memo provides only a brief summary of the tax consequences of short sales.  You should always consult your tax professional, accountant and/or attorney regarding individual short sale transactions.

 

 

 

 

The following articles are published for informational purposes and not for the purposes of providing legal advice. Please contact Galvin Realty Law Group at 425.248.2163 for a consultation about your specific needs and circumstances.