ANOTHER REASON TO CONSIDER LISTING FOR A SHORT SALE IF YOUR PROPERTY IS UNDERWATER: 12/31/12 EXPIRATION OF THE FEDERAL MORTGAGE DEBT FORGIVENESS ACT
Question: I own a property which is underwater (the secured debt exceeds the value) and I have been considering my options, including listing the property for a short sale or just letting the property go through foreclosure. I now have heard that adding insult to injury, if one of these events occurs, I may have to pay income tax on the transaction. How can this be?
Answer: Good question, and the frustration implied in your question is understandable. In the event of a short sale closing or a foreclosure, you may indeed have to face the possibility of having to pay income tax in connection with the transaction, and this is known as Cancellation of Debt Income (COD Income). Essentially, the Internal Revenue Service (IRS) takes the position that if you borrowed money from a lender, and then find yourself not having to pay it all back, you have just had taxable income equal to the difference between what you owe on the loan, and what the lender recovered, either through the short sale or foreclosure. As an example: assume you borrowed $200,000 secured by your property, negotiated a short sale which resulted in the lender only being paid back $100,000, and waiving the right to proceed against you for the deficiency of $100,000 (the difference between the amount the lender was owed, and the amount it got), then the lender will issue you a 1099-C and give a copy to the IRS. The 1099-C will say that you just had $100,000 of COD Income. So, not only did you just lose your property, but you now have to pay additional income tax to boot!
Luckily, there are several ways of being able to avoid the trap of COD Income. There are a number of available exclusions of the COD Income being treated as taxable income, which includes an insolvency exclusion (more on that in a later column), and an exclusion based upon the passage of the federal Mortgage Debt Forgiveness Act of 2007 (the MDF Act).
Essentially, if your property and the debt itself qualify for the MDF Act, 100% of the COD Income should be excluded from taxable income. Some of the requirements for qualification of the property and debt are:
1. The limit is $1 million for a married person filing a separate return and a maximum of $2 million for a married couple filing a joint return.
2. It applies to both short sales and foreclosures.
3. It applies to first position secured loans and junior loans.
4. Either a purchase or refinance loan will qualify, to the extent the proceeds were used for the purchase of the property, or to building or substantially improving the property. To the extent any loan proceeds were used for any other purpose, however, such as payment of a car loan or credit card debt, that portion so used would not qualify. Example: you obtain a new loan of $300,000 to payoff your existing loan of $200,000, and use the remaining $100,000 to pay off your kids’ student loans and credit card debt. $200,000 would qualify for the exclusion under the MDF Act, and the $100,000 used for the student loans and credit card debt would not (the insolvency exclusion, however, if applicable, could result in exclusion from taxation of the entire $300,000).
5. The property must be your principal residence. Investment property, such as rental homes, business property, second homes, as examples, would not qualify.
6. At the present time, the MDF Act sunsets and will only apply to debt forgiveness for transactions which close on or before December 31, 2012.
It is this latter element of the MDF Act which should get your attention. If you own a property underwater and are sitting on the fence as to whether to list the property for a short sale, you may want to act sooner than later. Many short sale transactions take a year or longer to complete, start to finish. As there is no certainty that the sunset date for the MDF Act will be extended, the exclusion from taxation of COD income could be lost if you wait and because of the delay can not close until after December 31, 2012.
Also, even if you are in a foreclosure situation, with a scheduled sale date which is set for a date before December 31, 2012, it would be a mistake to think you’re out of the water and will be able to take advantage of the MDF Act. Lenders have a right, as a matter of Oregon law, to extend, for any reason or no reason, the initial scheduled sale date for up to a maximum of 180 days (without having to start over), and you have no ability whatsoever to prevent any such postponement. So, for example, if a foreclosure sale of your property is set for July 15, 2012, the lender could elect to postpone the foreclosure date until January 10, 2013, and if the foreclosure sale occurs on that date, then you would have lost the potential benefit of the MDF Act (if not extended). Listing for a short sale at least gives you some ability (although not completely), to control your destiny as to your property.
Update on extension effort: On March 29, 2012, a number of senators (including our own Senator Merkley) introduced a bill to extend the expiration date of the MDF Act until January 1, 2015 (another two years). The bill, S. 2250, was referred to the Committee on Finance, but it does not appear there has been any further action on the bill. If you wish to track the progress of the bill, go to http://www.govtrack.us/congress/bills/112/s2250, and subscribe to track the bill.