TAXATION CONSIDERATIONS SURROUNDING DISTRESS SALES
REAL ESTATE LEGISLATION, SHORT SALES, TIPS FOR SELLERS
August 7th, 2008
Many property owners who purchased in the last few years with little or nothing down using a risky loan may be contemplating their options due to the inability to meet their mortgage payment obligations. Short sales, foreclosures and deeds in lieu of foreclosure are remedies with potentially unexpected tax consequences. Adding insult to injury, owners considering a distress sale may find out too late that two types of taxable income may be triggered by the transfer using one of the three remedies above. Capital gains and forgiveness of debt are types of taxable income that may result in a tax bill for the owner.
The tax rules are complicated. Speak to your accountant or tax preparer to advise you on the tax liability with each alternative. The variables include whether there was a foreclosure, short sale or deed in lieu of foreclosure; and whether the underlying debt is recourse or nonrecourse. Nonrecourse debt includes a loan to purchase 1-4 unit property in which the buyer intends to occupy one of the units or when the seller carries back financing for all or a portion of the purchase price. Recourse debt include refinances,home improvement loans, home equity lines of credit and loans to investors on 1-4 unit properties.
The calculations to figure the amount of realized (taxable income) for recourse debts require the following data:
- Fair Market Value (FMV)-this is usually the value of the property which equals the proceeds at the judicial foreclosure or trustee’s sale.
- Adjusted Basis -Usually the purchase price of the property plus any capital improvements (less depreciation if the property is investment property).
- Canceled debt -The unpaid loan amount or canceled debt.
First, calculate the difference between the FMV and the adjusted basis. This is the capital gain or loss. Second, take the difference between the canceled debt and FMV. This is the forgiveness of debt and is taxed as ordinary income even if the borrower received no cash at the time of foreclosure. However, if the canceled debt or “gift” is considered “qualified principal residence indebtedness” pursuant to the Mortgage Forgiveness Debt Relief Act of 2007, there will be no taxation on this forgiveness of debt income.
Qualified principal residence indebtedness is defined under IRC Section 163(h)(3)(B) as indebtedness discharged after January 1, 2007 and before January 1, 2010 and is a loan secured by the residence used to acquire, construct or substantially improve the residence. The income relief is capped at $1,000,000 in the case of a married person filing a separate return and $2,000,000 for all others. California Senate Bill 1055 is pending legislation that would provide conformity for state taxation purposes that mirrors the Debt Relief Act.
If the canceled debt fails to qualify, the realized amount is taxed as ordinary income (as opposed to capital gains income which is taxed at a lower rate. A Deed in Lieu of Foreclosure is treated for tax purposes just like a foreclosure. There are four exemptions from the taxation of cancellation of debt income:
- The taxpayer is insolvent (the taxpayer’s debts exceed their assets, but the cancellation of debt is forgiven only to the extent of the insolvency).
- The debt is discharged as part of a bankruptcy proceeding.
- The debt discharged is qualified farm indebtedness.
- The debt discharged is qualified business indebtedness.
Capital gains tax liability due to foreclosure or a deed in lieu of foreclosure or short sale may use their capital gain exclusion if the residence was the seller’s principal residence. This does not apply to ordinary income from cancellation of debt.
Which is the best remedy for an owner facing a distress sale? Any of these will negatively impact the owner’s credit score. Only a tax adviser can analyze your particular financial situation and recommend which method is best for disposition of a property. If I can answer any questions regarding this or any other real estate matter, please contact me as follows:
530-224-6767 or 530-941-7492
BRAD GARBUTT
REALTOR/BROKER
REAL ESTATE PROFESSIONALS GMAC
TWENTY FIVE YEARS LOCAL REAL ESTATE EXPERIENCE
