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Beware the Tax Bite on Short Sales of Principal Residences

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It is no secret that many people are underwater on their principal residences – they owe more than the home is worth. This is not just an issue for the masses. It also affects the top 1 percent.

Some realtors are specializing in “short sales”. The realtor presents the owner/ borrower with a contract to sell his property at a given price, subject to the holder of the mortgage agreeing to accept the net proceeds as satisfaction of the mortgage. The owner/ borrower is released from the obligation, the lender gets some money and avoids the foreclosure process along with insurance, real estate tax and maintenance costs on the foreclosed property.

What is usually not considered are the tax consequences to the former owner/ borrower.

Take the case of Dr. and Mrs. Taylor. They purchased a beautiful home at the top of the market in 2005 for $2,000,000, and borrowed $1,700,000, interest only. When the property appreciated, the couple pulled out an additional $300,000, and now owe $2,000,000. They can no longer afford to make the payments and the house is now worth about $1,200,000.

A realtor presents them a contact for $1,200,000, subject to the lender agreeing to forgive the shortage. The lender agrees to the short sale and receives $1,100,000 at closing after commissions, etc.

At the end of the year the lender is required to send an IRS Form 1099 – Discharge of Indebtedness Income Statement for $900,000 to the Taylors.

In general, for Federal Income Tax purposes, a forgiveness or discharge of debt is a taxable event. The theory is that the borrower has received an “economic benefit” – his net worth has been enhanced- through the discharge.

Congress did not like this result and has provided for three exceptions to the concept that discharge of indebtedness constitutes taxable income. The three exceptions are (i) Bankruptcy; (ii) Insolvency; and (iii) Qualified Principal Residence Indebtedness.

Under the Bankruptcy exception, there is no includible income to the borrower if he has his debt discharged in Bankruptcy. Of course, Dr. and Mrs. Taylor would have had to file before the short sale in order for the debt to be discharged in Bankruptcy. They did not do this because their tenancy by the entirety assets would have been lost to the mortgage holder. Since both spouses were personally liable on the mortgage note, tenancy by the entirety offers no protection.

The Insolvency exception applies only to the extent of the insolvency. Since the Taylors have a net worth over $900,000, the amount of the discharge, this exception provides them no relief.

The third exception for Qualified Personal Residence Indebtedness- is less straightforward. Here we need to compute how much of the debt is qualified and how much is not. Qualified debt is equal to “acquisition indebtedness” or the amount borrowed to purchase the residence or to improve it. Refinanced mortgages are acceptable up to the amount of the old mortgage debt. In no case can the qualified amount exceed $2,000,000. The theory is that Congress wants to forgive taxes only on the amount used to buy the residence or to improve it. Congress does not want to forgive taxes on dollars that were not used for this purpose.

Now back to the Taylors. They originally borrowed $1,700,000 to buy the house. They took out $300,000 a few years later when they refinanced. The acquisition indebtedness was $1,700,000 and the non-qualified amount- the amount borrowed that was not used to purchase or improve the house- is $300,000. Therefore, of the $900,000 discharged by the lender, only $600,000 qualifies as the other $300,000 was not used to acquire or improve the home. The Taylors have $300,000 of taxable income.

Moral of the story. Get tax advice before you jump at a short sale. Also don’t live beyond your means.

 

Source: Health Beat April 2012 Neweletter from The Law Firm of Kramer, Green, Zuckerman, Greene & Buchsbaum, P.A.

 


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