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Short Sales, Possible Tax Consequences and Bankruptcy

Given the state of the real estate market and the large mortgage debt that many people find themselves in, many of my clients find themselves upside down on their residences.  One of the questions I get asked most often by my clients is whether or not they should move forward with a short sale on their homes.  While a short sale is one way to get out from under the large mortgage debt you are facing there are some factors to consider before moving forward, the biggest of which being possible tax consequences.

When there is a short sale, you are selling your home for less than the amount that you owe on your mortgage or mortgages.  If your mortgage company agrees to release its mortgage lien on your residence for less then they are owed, the difference in the amount that is owed to the mortgage company and the amount the mortgage company nets from the sale is generally forgiven by the mortgage company, meaning that you don’t have to pay it.  The problem is that this forgiven debt is regarded as income to you, it is referred to as debt discharge income (DDI).  The mortgage company will send you a Form 1099-C (Cancellation of Debt) and will report the income to the IRS.

Happily enough, there are some taxpayer-friendly exceptions to the general rule that DDI is taxable, and they can save your bacon. Here they are in a nutshell:

* Up to $2 million of DDI from mortgage debt that was originally taken out to acquire, build, or improve the borrower’s principal residence is tax-free (you must reduce the basis of the residence by the tax-free amount). This super-favorable rule is not available for DDI from debt that was not used to acquire, build, or improve the principal residence such as DDI from a home equity loan used for other purposes. Rats! But don t give up hope. One of the other exceptions summarized below may work for you.

* If the borrower is in bankruptcy proceedings when the DDI occurs, the DDI is tax-free.

* If the borrower is insolvent (debts in excess of assets), the DDI is tax-free as long as the borrower is still insolvent after the DDI occurs. If the DDI causes the borrower to become solvent, part of the DDI will be taxable (to the extent it causes solvency). The rest will be tax-free.

* To the extent DDI consists of unpaid mortgage interest that was added to the loan principal and then forgiven, the forgiven interest that could have been deducted (had it been paid) is tax-free.

* If the DDI is from seller-financed mortgage debt owed to the previous owner of the property, it s tax-free. However, the basis of the property must be reduced by the tax-free DDI amount.

That is obviously a lot to digest and you should consult an accountant when trying to determine if you will in fact incur tax consequences from your short sale.  However, the key for most of my clients is if the mortgage on your residence is the original mortgage used to purchase the home, then there is probably no tax consequences. If you refinanced your mortgage only for a lower interest rate and did not take any money out when you refinanced, then there are probably no tax s.  If you refinanced and used any money that you took out for the improvement of your residence, then there is probably no tax consequence, but be prepared to prove what the money was used for.

Thus, it is very important that you consult with an attorney that is well versed in bankruptcy law before deciding if a short sale is the right option for you.  You should also note as I have previously discussed in a prior post, that a short sale is no better on your credit than is a foreclosure or a bankruptcy filing. Hence, if you are in the position to be considering a short sale, you should consider all of your options before proceeding.

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