03
Dec
12

Short Sales and Tax Relief

If your lender agrees to a short sale or to accept a deed in lieu, you may potentially incur income tax on any resulting deficiency. In the case of a short sale, the deficiency would be in cash and in the case of a deed in lieu, in equity.

The IRS’s position is as follows: When you first got the loan, you didn’t owe taxes on it because you were obligated to pay the loan back. However, when you didn’t pay the loan back and the debt was forgiven, the amount that was forgiven became “income” on which you owe tax.

The lender sends a 1099 to the IRS with the amount of the deficiency.

No tax liability for some loans secured by your primary home. In the past, homeowners using short sales or deeds in lieu were obligated to pay tax on the amount of the forgiven debt. However, the new Mortgage Forgiveness Debt Relief Act of 2007 changes this for certain loans during the 2007 through 2012 tax years only.

The new law provides tax relief if your deficiency arises from the sale of your primary residence. Here are the rules:

  • Loans for your primary residence. If the loan was secured by your primary residence and was used to buy or improve that house, you may generally exclude up to $2 million in forgiven debt. This means you don’t have to pay tax on the deficiency.
  • Loans on other real estate. If you default on a mortgage that’s secured by property that isn’t your primary residence (for example, a loan on your vacation home), you’ll owe tax on any deficiency.
  • Loans secured by but not used to improve primary residence. If you take out a loan, secured by your primary residence, but use it to take a vacation or send your child to college, you will owe tax on any deficiency.

The insolvency exception to tax liability. If you don’t qualify for an exception under the Mortgage Forgiveness Debt Relief Act, you might still obtain tax relief. If you can establish you were legally insolvent at the time of the short sale, you won’t be liable for paying tax on the deficiency.

Legal insolvency occurs when your total debts are greater than the value of your total assets (your assets are the equity in your real estate and personal property). To use the insolvency exclusion, you’ll have to prove to the satisfaction of the IRS that your debts exceeded the value of your assets.

Bankruptcy to avoid tax liability. You can also get rid of this kind of tax liability by filing for Chapter 7 or Chapter 13 bankruptcy, if you file before escrow closes. Of course, if you are going to file for bankruptcy anyway, there isn’t much point in doing the short sale or deed in lieu of, because any benefit to your credit rating created by the short sale will be wiped out by the bankruptcy.

Contact the Zarcone Law Firm today for a free, no obligation consultation – 619-800-3082 or by email.  Mention this blog post and save $50.00 off any bankruptcy filing.

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The content found on the financialfreshstart Blog is not legal advice and is purely for informational purposes. The Zarcone Law Firm does not guarantee the accuracy, integrity or quality of submissions. The information provided by the bloggers on this site may not represent the opinions of the Zarcone Law Firm or its affiliates. The information contained herein is not a substitute for the advice of an attorney.

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