Selling Your Home For Less Than You Owe The Bank? Don't Forget the IRS...

For those that don't know, a short sale is when a lender accepts a payoff amount that is less than the amount owed on a home. 

Here's an example of a short sale. 

• You owe $220,000 on your home
• You are missing mortgage payments and are 90 days late to the lender
• You have money in the bank
• Your home sells for $200,000
• After paying commissions and taxes, you have $184,000
• You tell the lender that you can't pay them back the entire amount that you owe
• The lender agrees to accept less than the amount owed because it's cheaper then going through foreclosure and they get most of the money back now.

With so many home values falling, selling without being able to payoff the full amount is much more common and short sales are being done on a far more regular basis.  For the homeowner, it looks great since they don't have to pay the full amount off....

Enter IRS.

According to IRS tax code, when a creditor agrees to cancel a personal debt of $600 or more, it is required to submit a Cancellation of Debt form to the IRS, otherwise known as a 1099-C.  When the IRS receives this form, it treats the canceled debt as income.

So, when the lender agrees to "forgive" the $36,000 in the short sale example above, it is required to report that write-off to the IRS.  The IRS, in turn, treats the write-off as income for the homeowner.

Assuming the 28% tax bracket, the homeowner added $10,080 ($36,000 * 0.28) of additional tax liability come April 15.  The fact that you didn't actually get cash at the closing is irrelevant.

Fortunately, relief may be on the way.  The House Ways and Means Committee is currently debating The Mortgage Cancellation Tax Relief Act of 2007, which would amend the tax code to forgive debt cancellations on primary residences.

Source: "IRS Kicks Homeowners While They Are Down", Kenneth Harney.  5 May 2007.

 

For those that don't know, a short sale is when a lender accepts a payoff amount that is less than the amount owed on a home. 

Here's an example of a short sale. 

• You owe $220,000 on your home
• You are missing mortgage payments and are 90 days late to the lender
• You have money in the bank
• Your home sells for $200,000
• After paying commissions and taxes, you have $184,000
• You tell the lender that you can't pay them back the entire amount that you owe
• The lender agrees to accept less than the amount owed because it's cheaper then going through foreclosure and they get most of the money back now.

With so many home values falling, selling without being able to payoff the full amount is much more common and short sales are being done on a far more regular basis.  For the homeowner, it looks great since they don't have to pay the full amount off....

Enter IRS.

According to IRS tax code, when a creditor agrees to cancel a personal debt of $600 or more, it is required to submit a Cancellation of Debt form to the IRS, otherwise known as a 1099-C.  When the IRS receives this form, it treats the canceled debt as income.

So, when the lender agrees to "forgive" the $36,000 in the short sale example above, it is required to report that write-off to the IRS.  The IRS, in turn, treats the write-off as income for the homeowner.

Assuming the 28% tax bracket, the homeowner added $10,080 ($36,000 * 0.28) of additional tax liability come April 15.  The fact that you didn't actually get cash at the closing is irrelevant.

Fortunately, relief may be on the way.  The House Ways and Means Committee is currently debating The Mortgage Cancellation Tax Relief Act of 2007, which would amend the tax code to forgive debt cancellations on primary residences.

Source: "IRS Kicks Homeowners While They Are Down", Kenneth Harney.  5 May 2007.