Tax Liabilities on a Foreclosure Short Sale

By: Nick Adama

When homeowners attempt to sell their house for less than the total amount they owe on it, certain tax liabilities may be triggered. This is one of the reasons that every foreclosure victim should carefully consider whether selling their house short is the right decision for them, and what other options may be available. The danger of getting an income statement on an IRS 1099 form at the end of the year for thousands of dollars may result in a higher tax liability than the homeowners originally anticipated.

Essentially, being 1099'd means that the homeowners, after the short sale has been used successfully to stop foreclosure, will be responsible for paying the taxes on the amount of debt that the bank forgives in order for them to proceed at all with the sale. Taxes would only have to be paid on the amount forgiven, not on the contract price, final payoff amount, or foreclosure judgment.

For example, if the foreclosure victims owe $150,000 on the mortgage, but the bank accepts $100,000 as their final payoff in order to facilitate the short sale, the difference of $50,000 is the amount that is counted as "forgiven debt." The IRS considers this $50,000 as if the bank gave the homeowners a gift for that amount, which was immediately used by the owners to pay down their mortgage. Therefore, taxes would be due on the amount given by the bank.

The homeowners would be responsible for paying taxes on the $50k, at whatever their marginal tax bracket will be that year. There are ways to get around this, though, such as if the homeowners are insolvent at the time of the sale. This means that, when the short sale went through, they owed more on the mortgage than the home was worth. To better understand the issues that may affect the tax liability on a short sale, it might be worth visiting the IRS website or consulting with a CPA to find out more before closing on the deal.

But the bottom line is that the homeowners facing foreclosure will only get a 1099 if the bank forgives any of the debt owed to them and allows the short sale. It will not be an issue if the house is otherwise disposed of, even if it is sold at a county sheriff sale for less than the total amount of the foreclosure judgment.

When the house is auctioned off at the sheriff sale, the bank does not forgive any of the debt. They are just using the legal mechanism of foreclosure to force the sale of the house and get back as much as they can. All that the bank has in this case is a loss, so there will be no income to the homeowners that can be considered as forgiven debt. The bank would not be able to show that the foreclosure victims received income in this form when the owners did not voluntarily sell the property and the mortgage company did not voluntarily forgive any of the debt. No voluntary agreement to take a lower payoff equals no forgiven debt equals no extra income tax liability.

Since the whole foreclosure process is coercion by the state to sell a property to enforce a contract, a sheriff sale would not be an event that triggers extra income to the homeowners. A short sale, though, can be an extremely effective resolution to stop foreclosure, especially in the type of real estate market as exists right now. Many homeowners are underwater with the equity in their homes, and they are much more likely now to fall under the insolvency exclusion than they were even a few years ago during the real estate boom.

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