IT'S A HOMEOWNER'S worst nightmare: selling your home at a loss. Sadly, many folks have discovered just how devastating this can be.
The worst-case scenarios are when people borrow heavily to buy a home at the top of a run-up in the real estate market, or take out big home-equity loans while prices are inflating. Once the real estate market turns and home values start dripping, these two situations can result in having the mortgage debt exceed the value of the home. And if homeowners in these situations have to sell, not only will they owe money to the bank, but there could be some unexpected income tax consequences to boot.
A home sale where the mortgage debt exceeds the net sale price (after subtracting out commissions and other transaction costs) is often called a short sale by real estate types. If you find yourself in this situation, here's what you need to know about the federal income tax implications of short sales.
Short Sale Tax Basics
Naturally, this subject is a bit complicated. The easiest way to explain matters is with some examples.
Example 1: Say you paid $260,000 for a home that you can now sell for a net sale price of $300,000. Unfortunately, you also have $350,000 of first and second mortgages against the property. For tax purposes, you'll have a $40,000 gain if you sell, because the sale price exceeds your tax basis in the home ($300,000 sale price - $260,000 basis = $40,000 gain). The IRS doesn't care that you're still $50,000 in the red after the sale ($350,000 of debt vs. the $300,000 sale price). The bottom line is you can have a tax gain without actually having any cash to show for it.
The good news is that you will probably qualify to exclude the $40,000 gain for federal income tax purposes thanks to the home sale gain exclusion break. (Click here for more on this.) So the sale probably won't trigger a federal tax bill. Depending on where you live, there may or may not be a state income tax hit. Fair enough.
Of course, you can also have a short sale where the net sale price is less than what you paid for the home.
Example 2: Say you paid $340,000 for a home that you can now sell for a net sale price of $300,000. You also have $350,000 of first and second mortgages against the property. For tax purposes, you'll have a $40,000 loss if you sell because the sale price is lower than your tax basis in the home ($300,000 sale price - $340,000 basis = $40,000 loss). Ouch!
Will the IRS let you claim a write-off for the loss? Nope. You can only claim a tax loss on investment property. A loss on a personal residence is considered to be a nondeductible personal expense for federal income tax purposes. Most states follow the same principle. Double ouch!
Now, what about that $50,000 that you still owe the mortgage lender in both of the preceding examples? Good question. In most cases, the lender won't let you off the hook for any of the debt. You'll have to figure out a way to pay it off, and you won't get any tax breaks for doing so.
If you're more fortunate, the lender could decide to forgive some or all of the unpaid $50,000. (This may happen if the lender thinks it's unlikely you'll be able to repay the full amount.) To the extent debt is forgiven, you have so-called debt discharge income (DDI) for tax purposes. Here's what happens with that:
Debt Discharge Income Basics
The general rule is that DDI is a taxable income item. For the year that DDI occurs, the lender should report the amount to you (and to the IRS) on Form 1099-C (Cancellation of Debt). As stated, you generally must report the DDI as income on your return for that year. However, there are some exceptions to the general rule that DDI is taxable.
The Mortgage Forgiveness Debt Relief Act of 2007 created a new exception for qualifying discharges of principal residence debt that occur through 2012. Under the exception, a homeowner can have up to $2 million of federal-income-tax-free DDI from "qualified principal residence indebtedness," which means debt that was used to acquire, build or improve your principal residence and that is secured by that residence. You must then reduce the basis of your principal residence by the amount of DDI that goes untaxed.
Beware: This exception only applies to DDI from debt that was used to acquire, build or improve your principal residence. DDI from discharges of home equity loans used for other purposes won't qualify nor will DDI from discharges of vacation home loans. (However in these circumstances, the other DDI exceptions mentioned below could help you out.)
If the borrower is in bankruptcy proceedings when the DDI occurs, the DDI is entirely excluded from taxation.
If the borrower is insolvent (which means your debts exceed the value of your assets), the DDI is entirely excluded from taxation as long as the borrower is still insolvent after the DDI occurs. If the DDI causes you to become solvent, part of the DDI will be taxable (to the extent it causes solvency). The rest will be excluded from taxation.
To the extent DDI consists of unpaid mortgage interest that was added to the loan principal and then forgiven, the forgiven interest that you could have deducted (had you paid it) is excluded from taxation.
If the DDI is from seller-financed debt (i.e., mortgage debt owed to the previous owner of the property), it is excluded from taxation. However, your basis in the property must be reduced by the excluded DDI amount. If you then sell the property for a gain, the gain will be that much bigger. As explained earlier, however, you can probably exclude the gain under the home sale gain exclusion rules.
Taxable Gains and DDI Can Also Arise in Foreclosure
So far, we've only covered short sales where you sell your home to a third party. But what happens tax-wise if the mortgage lender forecloses? Here is the general rule. Say your property is foreclosed (or transferred to the lender via a deed in lieu of foreclosure). When the mortgage debt exceeds the property's fair market value (FMV), the transaction is treated as a sale for a price equal to FMV. Naturally, the sale will trigger a tax gain if the FMV exceeds your tax basis in the home. Once again, however, you can probably exclude the gain under the home sale gain exclusion rules.
If the lender then forgives all or part of the difference between the higher amount of the mortgage debt and the lower FMV of the home, the forgiven amount is DDI, and it's taxable unless one of the exceptions explained earlier applies.
Here's another example to help bring things into focus.
Example 3: Say you borrowed against your home when local property values were rising steadily. The chickens came home to roost, and the home was foreclosed. Assume its FMV was $300,000 at the time of the foreclosure. Your tax basis in the home was $240,000. The property was burdened by a $200,000 first mortgage and a $150,000 second mortgage (total debt of $350,000).
Assume the full $200,000 first mortgage balance and $100,000 of the second mortgage principal get paid off when the lender sells the property. You manage to scrape together $10,000 to pay off part of the remaining second mortgage balance. The lender forgives the last $40,000. Here are the federal income tax results.
The foreclosure triggers a gain of $40,000 ($300,000 FMV - $260,000 tax basis = $40,000). Assuming you qualify, the gain can be eliminated by the home sale gain exclusion break. The second mortgage lender's forgiveness transaction triggers $40,000 of DDI. That amount must be reported as income on your tax return, unless one of the exceptions explained earlier applies.
The Last Word
The important thing to understand here is that a real estate short sale or foreclosure can potentially result in a taxable gain and/or taxable DDI. That's the bad news. The good news is that you can probably exclude the gain from taxation, and you might be able to exclude some or all of the DDI too. Let's hope so, because having to pay taxes in this situation is truly adding insult to injury.