For many homeowners considering a short sale of their property, among the most important factors is whether and to what extent they may face a tax liability as a result of the transaction. The concern is well founded.
As a general rule, the IRS requires that any lender receiving less than the full amount of mortgage debt owed on a property must send the borrower a Form 1099 for that “deficiency” amount. In other words, if you owe $250,000, and you short sell your property for $190,000, you will receive a Form 1099 for $60,000.
The most important question is whether you have to pay taxes on that $60,000 of “income.” Prior to the collapse of the housing market, the income was virtually always taxable. In 2007, Congress passed the Mortgage Debt Relief Act, which generally allows taxpayers to exclude income from the discharge of debt on their principal residence. For purposes of the Act, the IRS defined “principal residence” as a property in which the taxpaper lives for a total of 24 of the 60 months preceding the discharge of the debt.
It is important to understand that the tax exemption does not apply to all debt on a principal residence. The Act applies only to forgiven or cancelled debt used to buy, build or substantially improve your principal residence, or to refinance debt incurred for those purposes. In addition, the debt must be secured by the home. The maximum amount you can treat as qualified principal residence indebtedness is $2 million or $1 million if married filing separately.
Where a homeowner has “cashed out” equity in a principal residence through refinance or a home equity line of credit for unrelated purposes, the tax exemption does not apply. Similarly, the exemption does not apply to non-principal residences; i.e., rental or income property.
Now here’s the important part: THE ACT EXPIRES ON DECEMBER 31, 2012! In other words, if you want to benefit from this very important tax exemption by short selling your home you need to start NOW. Any delay risks having the sale not be approved, and as a result not closing, before the expiration of the act.
There is a chance that the Act may be extended; however, the current lack of bipartisan cooperation in Washington raises the very real chance that nothing will get done before the next Congress is sworn in next year. And there’s no guarantee the new Congress will pass the legislation necessary to revive the Act. Under the circumstances, my advice is better to be safe than sorry.
If you have questions about whether you qualify for the exemption, or have other issues relating to your mortgage, short sales or foreclosures, please contact my office and let’s talk.