Debt Relief, Short Sales, Deficiencies, Oh My! (think Lions, and Tigers and Bears …)
Question: I am considering selling my home in a short sale, but my Oregon real estate broker has told me that I may be subject to taxes because of the December 31st expiration of a federal act providing relief to distressed homeowners from 1099 income. Is this true, and if so, should I cancel my plans to sell my home.
Answer: Not necessarily. While the federal act providing relief from taxes on the forgiven debt is currently set to expire, there are still substantial benefits for considering a short sale rather than facing foreclosure.
A bit of background. The federal act referred to is the Mortgage Forgiveness Debt Relief Act (the “Act”). The Act was intended to provide relief to distressed homeowners from phantom income in the form of cancellation of indebtedness (the 1099 income). Such income may arise when a short sale or a foreclosure occurs, the lender receives less than what is owed on the loan (the deficiency) and the lender either agrees to forego collection of the deficiency, or is barred by law from collecting the deficiency. This deficiency is then reported to the IRS by the lender and treated as taxable income to the homeowner. Simple example: mortgage balance is $300,000, home is sold for $200,00, and deficiency is $100,000. If homeowner does not have to ever pay back this deficiency to the lender, it is treated as the 1099 income of $100,000, and tax must be paid on it unless there is an applicable exclusion.
The Act provides an exclusion of this 1099 income from taxation if certain qualifying criteria are met, primarily being that the property was the primary residence of the homeowner and that the debt was incurred in connection with the purchase or refinance or improvement of the property.
Unfortunately the Act is set to expire December 31st of this year, and while there are efforts coming from multiple parties to get the Act extended (including a request of 41 state attorneys general), at this point in time there is no indicator that Congress will act (one company tracking the status of the Act says there is only a 9% chance of the Act being extended). It should be emphasized, however, that even if the Act expires, it could be resurrected in the next Congress in 2013.
Where does this leave the homeowner, and where does this leave short sales? All is not lost for the homeowner, and there are still legitimate reasons for a homeowner closing a short sale.
Act May Be Revived and Insolvency Exclusion
Even if the Act expires, the next Congress could provide retroactive relief.
There may be other exclusions from the 1099 income available to the homeowner in the form of the insolvency exclusion. A tax professional should be consulted before a determination is made that it applies, and the relief afforded. A helpful IRS pamphlet on the subject, including a worksheet to determine insolvency, can be found at: http://www.irs.gov/publications/p4681/ch01.html.
Short Sales Still Valuable
If there are both a primary loan and a second loan against the property, a short sale may still be the best way for a homeowner to negotiate a complete waiver of any deficiency claims by both lenders, and without any contribution by the homeowner. Even without any ability to avoid the 1099 Income, the tax on the cancelled debt will still be substantially less than the amount of the deficiency claims.
It does provide the homeowner control over your own destiny. While lender still has to approve the terms of any short sale, making a decision to proceed with a short sale and going through the process does provide an element of control to the homeowner which does not exist when the decision making is left entirely to the lender in the foreclosure process.
Because of new legislation and new case law in Oregon, judicial foreclosures, as opposed to foreclosures by advertisement and sale, have become the norm. If you own investment property or the trust deed being foreclosed is not a “residential trust deed” the lender may be able to obtain a judgment for the deficiency after the sheriff’s sale, and attempt to collect against other assets you own. A negotiated short sale can assist in avoiding this result.
Decisions regarding the disposition of one’s property has become far more complex. A homeowner should work closely with the team of the real estate broker, attorney and tax professional in making the final decisions regarding how best to proceed.