Worse tax bite: short sale or foreclosure?

REThink Real Estate

By Inman News Feed
Add Comment Add Comment | Comments: 0 | Posted Mar. 3, 2011

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REThink Real Estate

Tara-Nicholle Nelson
Inman News™

Q: Is there a difference on how you are 1099'd on a short sale vs. foreclosure for California residents? Is a foreclosure more "forgiving"? --Barb

A: Before we delve into a serious subject, I want to share something funny (and tangentially relevant) that happened to me the other day. "My mother sent me a text message that read: If I send you an address, can you tell me whether it is a shortcake?"

I'm pretty sure she meant short sale, and her texting software's auto-correct function actually transformed it to the much more pleasant confectionery delight.

Anyhow, let's start from a place of clarity. Internal Revenue Service Form 1099 is the form on which miscellaneous forms of taxable income are reported to taxpayers, who are then required to report this income on their tax returns (and pay taxes on it as required by their financials and the tax code).

In every state, every short sale or foreclosure can give rise to the bank issuing the borrower/former homeowner a form 1099 to report what is called Cancellation of Debt Income (CODI).

The theory is that you were not required to report the money you borrowed as income at the time you took the mortgage, because it was not income -- it was a loan. When any portion of that debt is forgiven, whether through a short sale, a loan modification or a foreclosure, those funds convert from a loan to income, and must be reported to the IRS.

Any lender that wipes out debt in the context of a loan restructuring or a foreclosure has the right to issue the former borrower a 1099 form on the deficiency amount: the difference between what the lender recoups on the property through auction sale, short sale or a reduced loan balance, and what the borrower owed on the property. (The lender may not do it, but has the right to -- and most lenders do.)

As a result, in foreclosures involving equity lines or loans or refinance loans that resulted in cash out (i.e., were not used to purchase the home or to refinance a purchase loan), that bank may not issue a 1099 because that line or loan has not been forgiven -- the bank retains the right to pursue the borrowers for those funds in California.

Early on in this housing crisis, it was widely believed that a short sale would generate income tax while a foreclosure would not. This was largely misinformation, misinterpretation and misunderstanding of the relevant tax rules, largely due to the fact that we had simply seen very few cases of short sales or foreclosures until this wave of foreclosures came four years ago.

I think the (incorrect) belief was that a short sale was elective while a foreclosure was not. In fact, in 2006 I actually represented a would-be buyer on a property where the sellers decided to let the home go to foreclosure vs. closing on our short sale, out of the false belief that they would incur a great deal of income taxes on a short sale and none on a foreclosure.

As we now know, several years into this housing crisis, both foreclosures and short sales involve 1099s and cancellation of debt income. However, under the Mortgage Debt Forgiveness Relief Act of 2007, the IRS is not charging income tax on most mortgage debt forgiven through short sale or foreclosure -- especially on a borrower's primary residence, and with a few other conditions -- so long as that foreclosure, short sale or loan mod occurs before the end of the 2012 calendar year.

While there was a brief period of time during which California's state tax law did not align with this temporary federal tax exemption, California's law now mirrors the federal law.

A couple of points of note: Lenders are taking a long time to foreclose now -- 16 months after no payments, on average nationwide, and much longer in some areas. Many homeowners considering a strategic default vs. a short sale should at least make an effort at a short sale, especially given that there's no guarantee that a foreclosure will occur before the end of 2012 even if they stop making payments now.

Unless the Mortgage Debt Forgiveness Relief Act is extended, former homeowners who lose their homes after 2012 could be subject to income taxation at their regular tax bracket on the deficiency amount -- sometimes hundreds of thousands of dollars.

There are a number of other exceptions to this taxation that apply at all times, though, including an insolvency exemption for those with a negative net worth, that may apply to many upside-down homeowners -- more detail is available at the IRS website for the Mortgage Debt Forgiveness Relief Act.

To be fair, I must mention that many experienced short-sale listing agents advise borrowers to stop making payments before requesting a short sale, too, as a number of major lenders and loan servicers do not seriously consider any sort of loan workout requests from borrowers who are current on their loans.

Before you make a decision about whether to attempt a short sale or let your home go to foreclosure, consult with a tax professional and get fully briefed on how the relevant tax laws will affect you.

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