July 12, 2010
The Housing Market and Short-Sales: A Taxable Event?
A short sale occurs when the home owner and the lender enter in to an agreement whereby the homeowner sells the property and the lender agrees to accept less money than currently due.
While the idea and process of a short-sale is not new, due to the recent downturn in the housing market across the country, many short-sales are just now closing due to the associated somewhat long process. As a short-sale closes, a 1099-C (Cancellation of Debt) must be issued. Taxpayers in receipt of the form are now asking: “Do I have to pay tax on this?” Of course, the answer is – “that depends”.
As a result of the short sale, the homeowner (seller) has cancellation of debt (“COD”) income. COD occurs when a debt is agreed to be settled for less than the outstanding balance. The amount of COD is the difference between the actual balance owed to the lender and the amount the lender agreed to accept in satisfaction of the loan. The lender is required to report the amount of debt forgiven on Form 1099-C which is forwarded to the IRS, as well as the taxpayer who is receiving the debt relief. Amounts reported on Form 1099-C should be reported on the taxpayer’s tax return, and unless excluded from income, are taxed as ordinary income.
In order to alleviate the tax burden of the COD income, there are some helpful provisions contained in the Mortgage Forgiveness Debt Relief Act of 2007, (the “Act”).
Under the Act, a discharge of "qualified principal residence indebtedness" is excluded from taxable income. "Qualified principal residence indebtedness" is acquisition indebtedness secured by the principal residence of a taxpayer, and used to acquire, construct or substantially improve the residence. If any portion of the debt was used to pay off credit cards, car loans, or any other personal use, it will not qualify for the exclusion. In order to qualify for the exclusion, the following criteria must also be met:
- The property sold in the short sale is the taxpayer's principal residence.
- The exclusion applies only to indebtedness discharged after January 1, 2007 and before January 1, 2010.
- The exclusion is limited to $2,000,000 for all taxpayers, except those filing as married filing separately, in which case the cap is $1,000,000.
When proceeds from a refinancing were used for personal purposes, some complications arise. These amounts are not excluded by the Act but are not automatically subject to tax either. The COD can be excluded from income to the extent insolvent immediately after the short sale closes (i.e., liabilities still exceed assets).
Taxpayers who receive a form 1099-C and have COD income will be required to complete and file Form 982 to properly report the income and exclusion amounts.
While the above dates for the allowance of the exclusion have not been extended under more recent provisions, it is likely that many taxpayers are currently in the process of completing their 2009 personal income tax returns and these exclusions should be considered.
Should you have any questions related to COD or other provisions of this Act, please contact your MarcumRachlin Tax Professional.