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Taxing Consequences of Short Sales
By: Gregory Braun, Partner; Michael Friman, Partner; Beth Prendergast, Associate

What is a Short Sale?

Declining home prices have left many homeowners in the unfortunate situation of owing more on their mortgage than the current value of their home.  When the homeowner desires to sell the property but cannot completely pay off the mortgage, the lender may agree to accept the sales price as full payment on the loan, as forgiving part of the loan is often more practical than pressing the borrower for the balance.  Selling the property in this situation is known as a “short sale” – selling for a net sales price that is less than the outstanding mortgage debt.  Both the homeowner and lender consent to the short sale in order to avoid foreclosure on the property.  The forgiveness of debt often provides tremendous relief to the homeowner.  However, it may also create “debt discharge income” of “forgiveness of debt income” upon which the homeowner must pay taxes.[i][i]

What are the tax consequences of a short sale for the homeowner?  Consider the following examples:

Tax gain on short sale:

Suppose the homeowner paid $400,000 for his principal residence.  He has $450,000 of first and second mortgages on the property because he took out a large home equity loan when the property was worth $600,000, before the real estate market crashed.  Now, the homeowner wants to sell the property, however, the most he can get is $500,000.  For tax purposes, the sale will leave the homeowner with a gain of $100,000 because the sales price is higher than his tax basis in the home.  The homeowner must report this $100,000 gain as income, even though he still owes $50,000 on the mortgages because mortgage debts do not enter into the gain-on-sale calculation.  However, $250,000 ($500,000 if married, filing jointly) of this gain is not taxable, even though it is reported, if the homeowner lived in the home for two of the last five years. 

            $500,000 sales price
-          400,000 basis[ii][ii]
            $100,000 gain

Tax loss on short sale:

Suppose the homeowner paid $400,000 for his principal residence, but he can now sell it for only $300,000.  He has $350,000 of first and second mortgages on the property.  For tax purposes, the sale will leave the homeowner with a loss of $100,000 because the sales price is lower than his tax basis in the home. Even though the taxpayer suffered a loss, he cannot write it off for tax purposes because the IRS considers a loss on a personal residence to be a nondeductible personal expense. 

            $300,000 sales price
-           400,000 basis                     
            $100,000 loss

General Tax Consequences of Debt Forgiveness

Generally, a borrower must report cancelled debt as income.  A borrower is not required to include loan proceeds in income for the tax year in which he takes out the loan because he has an obligation to repay the lender.  If the lender subsequently forgives or cancels that obligation, the amount the borrower received as loan proceeds is normally reportable as income to the borrower since he no longer has an obligation to repay the lender.  This reporting rule can have tax implications for the homeowner in the case of a short sale.

In both examples, the mortgage debt exceeds the sales price by $50,000.  To the extent that the lender cancels or forgives this excess debt, the homeowner will have “debt discharge income” which he also must report as taxable income.  The net result in both examples leaves the homeowner in an undesirable tax position.

Exceptions to the Rule
Fortunately for the homeowner, there are exceptions to the general rule that discharged debt is taxable income.  The most common of such situations involve:

• Bankruptcy: Debt discharged through a bankruptcy proceeding is not considered taxable income.
• Insolvency: If the borrower is insolvent when the debt is cancelled, some or all of the cancelled debt may not be taxable to the borrower as long as he is still insolvent after the debt discharge occurs.  If the debt discharge causes the borrower to become solvent, it will be taxable only to the extent it causes solvency; the rest will be tax-free.  A borrower is deemed insolvent when his total debts exceed the total fair market value of his assets. 
• Non-recourse loans: A non-recourse loan is a loan for which the lender’s only remedy in case of default is to repossess the property being financed or used as collateral (i.e., the borrower is not personally liable for the loan). Forgiveness of a non-recourse loan resulting from a foreclosure does not result in cancellation of debt income. However, it may result in other tax consequences.
• Direct farm debt: Certain debt incurred directly in operation of a farm.
• Qualified real property business indebtedness: The Mortgage Debt Relief Act of 2007 generally allows taxpayers to exclude income from the discharge of debt on their principal residence, including income realized as a result of foreclosure.

More on the Mortgage Debt Relief Act

Up to $1 million ($2 million if married, filing jointly) of debt forgiven in calendar years 2007 through 2012 is eligible for exclusion under the Mortgage Debt Relief Act.  Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief.  The exclusion applies only to forgiven or cancelled debt used to buy, build or substantially improve the taxpayer’s principal residence.  Refinance debt incurred for the same purposes qualifies for the exclusion, but only to the extent that the principal balance of the old mortgage, immediately before the refinancing, would have qualified.  Therefore, cash out refinance debt, where the money was not used to improve the home, does not qualify.  Nor does the exclusion apply if the discharge is due to services performed for the lender or any other reason not directly related to a decline in the home’s value or the taxpayer’s financial condition.

Bottom Line - What Does a Short Sale Mean for the Homeowner?

A short sale can potentially result in a taxable gain, a loss that cannot be written off, and/or taxable debt discharge income for the homeowner. Fortunately, although the amount of debt forgiven must be reported as income, the homeowner may be able to exclude such income under one of the exceptions highlighted in this article.  Homeowners should consult with tax and legal counsel experienced in such matters before considering a short sale. 

McCormick Braun Friman, LLC regularly advises homeowners (and lenders) in the short sale process, both from a legal and tax perspective.