Tax Consequences of Selling Real Estate in a Short Sale

    At my seminars in through emails, and daily conversations, I am being frequently asked on how taxes relate to short sales. Seeing as I am not a tax accountant, I don’t give tax advice; I always send my potential short sale candidates to a versed short sale accountant, as you should also. To help everyone out there I had my accountant just right a very brief explanation of how taxes relate to short sales. Granted it goes deeper than this, this is just the basics, as we will go into more complex situations in the next article post.

    Tax Consequences of Selling Real Estate in a Short Sale

    Tax Consequences of Selling Real Estate in a Short Sale
    By: Christopher S. Robins, CPA Twilley, Rommel & Stephens, P.A., Salisbury, MD
    Whenever real estate is sold there are potential tax consequences for the seller. In a short sale, real estate that is subject to mortgage debt in excess of its fair market value (“underwater”) is sold to a third party with the consent of the lender to accept the sales proceeds in satisfaction of the debt. The property could be a principal residence, a second home, or investment property. Dealing with the tax issues related to a second home, rental or investment property can be challenging. The tax implications of these transactions will be addressed in another article.

    The amount realized on a sale of property depends on the type of financing: •

    Nonrecourse Debt. The borrower is not personally liable to repay the debt even if the value of the property is less than the outstanding debt. •

    Recourse Debt. The borrower is personally liable to pay any amount of the debt not satisfied by the value of the property.
    It is rare for a residential mortgage to be nonrecourse. If a principle residence is sold in a short sale with nonrecourse debt, the amount realized is the full amount of the debt, even if greater than the property’s fair market value. Because the discharged debt is treated as part of the amount realized, there’s no discharge of indebtedness income.

    If the cancelled debt in a short sale was recourse, the transaction may be taxable income to the seller/debtor in two ways: •

    The discharged debt is taxable if it does not meet one of the exclusions discussed below •

    The sale results in a taxable gain and does not qualify for the federal tax exclusion from the sale of a principle residence

    The major exclusion is the Mortgage Debt Relief Act of 2007 which provides for taxpayers to exclude from their income up to $2 million of qualified principal residence indebtedness. This is debt incurred to acquire, construct or substantially improve the taxpayer’s principal residence. A refinancing of such debt also qualifies. The exclusion applies where a taxpayer restructures the acquisition debt on a principal residence, loses a principal residence in a foreclosure, or sells a principal residence in a short sale. “Principal residence” is defined as the home where the taxpayer ordinarily lives most of the time. A taxpayer can have only one principal residence at a time.

    When cancellation of debt income cannot be excluded under the qualified principal residence acquisition rules, see whether another exclusion applies. Generally, debt forgiveness is taxable, unless one of the exclusions applies. Other exclusions include: •

    Bankruptcy: Debts discharged through bankruptcy are not considered taxable income •

    Insolvency: If a homeowner is insolvent when the debt is cancelled, some or all of the cancelled debt may not be taxable. •
    Certain farm debts: If you incurred the debt directly in operation of a farm, your cancelled debt is generally not considered taxable income These exclusions as well as other tax implications of real estate will be discussed in future articles.

    Trackback from your site.

    About our blog

    Our agents write often to give you the latest insights on owning a home or property in the local area.