Homeowners Relief from Real Estate Short Sales Hidden Tax

Mortgage Forgiveness Debt Relief Act assuaged fears of most East Bay homeowners facing foreclosures

Alan L. Olsen, CPA, MBA (tax)  

by Alan L. Olsen, CPA, MBA (tax)
Managing Partner
Greenstein Rogoff Olsen & Co. LLP

The sub-prime mortgage debacle is still playing out nationwide, with new home sales plummeting 61 percent since January, foreclosure rates doubling, and the number of borrowers 90-days or more in areas growing. In Northern California, East Bay homeowners – particularly, those residing in Contra Costa County, where many buyers make their first foray into the challenging Bay Area housing market – have been hit particularly hard.

Of course, homeowners who now face foreclosure are seeking ways to ease the pain of this nightmare and avoid the black mark it will leave on their credit rating. However, many can’t or simply don’t want to go through the hassle of refinancing or asking their lender to modify the terms of their loan. Instead, many are turning to another “solution”: the short sale. In this type of transaction, a homeowner – with the mortgage lender’s approval – sells his or her property for less than the amount owed on the mortgage.

While lenders will allow some homeowners to take the short-sale route, they agree to it grudgingly because they stand to lose a big chunk of the loan’s value. Homeowners also must prove to the lender that they cannot make their mortgage payments; this can take weeks and is essentially the equivalent of an audit. In addition, while a short sale ultimately may be less painful to endure than a foreclosure, it does not guarantee an unblemished credit report because the lender can notify a credit bureau of the transaction.

Relief for some homeowners

Another downside to the short sale in the past has been the Internal Revenue Service’s expectation that homeowners count mortgage debt forgiven by a lender as earned income and pay tax on it. Consider this example: A homeowner owes $500,000 on a house purchased for $530,000. It is now worth $480,000. If the property is foreclosed, and the homeowner gives the property to the lender – or if the lender accepts a short sale arrangement – then the homeowner is taxed as if the property had been sold for $500,000. Depending on the situation, the former homeowner likely could be on the hook for thousands of dollars of tax.

However, there is some good news to report on this front: Because of the Mortgage Forgiveness Debt Relief Act of 2007 (enacted on December 20, 2007), today, the homeowner in the above example might not be subject to this extra income tax – provided they are selling their principal residence. In fact, if a lender forgives a portion of a homeowner’s mortgage on a principal residence in 2007, 2008 or 2009, the homeowner will not be taxed on that debt reduction, whether it is the result of a short sale or a mortgage restructuring process.

There are a few things for homeowners to keep in mind about the Act: 

  • The tax break it provides applies only to indebtedness that is used to buy, build, or substantially improve the homeowner’s principal residence – not an investment property or a second or vacation home. Also, homeowners who tapped equity in their home for other reasons, such as paying off a credit card, do not qualify for tax relief on that debt.
  • If the principal balance of the loan used to buy, build or substantially improve a principal residence was less than $2 million – or $1million for a married person filing a separate tax return – there is no limit on the amount of qualifying indebtedness forgiven that can be excluded as income.
  • The provision applies only to qualified home mortgage debt discharged or forgiven between January 1, 2007, and December 31, 2009

Because qualified forgiven debt may not generate a tax bill from the federal government, the short sale has become an even more attractive option for some homeowners facing foreclosure. However, before deciding on this approach, homeowners should be sure to seek the advice of a qualified certified public accountant for more details about qualifying rules and regulations related to the Mortgage Forgiveness Debt Relief Act.

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