Short Sales – Taxes & IRS Form 1099

These days, short sales – selling for less than is owed with the mortgage holder forgiving the balance – are as common as college students sporting tattoos. In a depressed housing market, sellers getting off the hook on their mortgage loans might seem like a slice of heaven. But is not having to pay every penny owed really as good as it sounds?

Suppose Carol bought a house a few years ago for $300,000, putting $15,000 down and signing a promissory note and mortgage for $285,000. Today, she needs to sell but can’t find a buyer willing to pay more than $250,000. To make matters worse, Carol still owes $275,000. But because Carol lost her job and is financially strapped, her lender is willing to take $230,000 (sale price minus sale expenses) to release its mortgage. Carol is bummed about her sale price but ecstatic at getting the house off her back.

But are Carol’s financial woes really over?

To figure that out, we have to know what really happened between Carol and her lender. In most cases, there are three possibilities: (1) The lender might expect Carol to pay the $45,000 shortfall later, having agreed to release its mortgage but not cancel Carol’s note. (2) The lender might have required Carol to sign a new note for $45,000 in exchange for releasing its mortgage. (3) The lender might have cancelled the $45,000 balance, taking the you-can’t-get-blood-out-of-a-turnip approach.

If the answer is (1) or (2), the good news is Carol doesn’t have a tax consequence; the bad news is she still owes $45,000. If the answer is (3), the good news is she doesn’t owe the $45,000; the bad news is her lender will send her a 1099-C showing debt cancellation to the tune of $45,000, meaning Carol may have to pay taxes on it at ordinary income tax rates.

You ask, “What do you mean ‘may have to pay taxes on it’?”

Here’s the scoop. When real estate is sold, the seller may incur tax consequences. In Carol’s case, she will receive a 1099-S showing the sale price of $250,000 but she won’t owe a capital gain tax because she’s selling for less than her tax basis (in this case, that’s the amount she bought it for). But she may owe income tax if her lender has cancelled the $45,000 shortfall (resulting in the 1099-C). Why? Because to the IRS, debt forgiveness is the same as income, which means the $45,000 forgiven will be treated as if Carol was handed $45,000 in cash – unless Carol qualifies for exclusions recognized by the IRS.

In the residential real estate world, special exclusions apply to owner-occupied principal residences. Best known is the capital gain exclusion, allowing sellers to enjoy a gain of up to $500,000 for married couples filing jointly ($250,000 for individuals) upon sale of their houses. But there’s another helping hand, thanks to the Mortgage Debt Relief Act of 2007. The 2007 law provides that debt forgiven or cancelled in calendar years 2007 through 2012 is excluded from income realized as a result of mortgage modification, foreclosure, or short sale. In other words if you can’t pay off your mortgaged home and your lender cancels some or all of your debt, you don’t have to pay income tax on the amount cancelled.

Back to Carol. If Carol’s house was her principal residence (and she didn’t move out more than 90 days before the debt was cancelled), she won’t have to treat the $45,000 as income. Otherwise she will, unless she can show she was insolvent (total debts greater than total assets) at the time of cancellation or if Carol’s debts are discharged in a Chapter 7 bankruptcy proceeding.

Tread carefully though, because not all cancelled debt is subject to the exclusion – even on a principal residence. For example, the debt forgiven must have been used to buy, build, or substantially improve the principal residence, or to refinance debt for those purposes. So, if the seller refinanced the house and took out cash – say, to buy a car – the cash portion would not qualify for the exclusion. But if the exclusion does apply, up to $2-million may be forgiven tax-free (married, filing jointly; $1-million if filing separately).

By the way, the onus to give the 1099-C is on all lenders forgiving debt of $600 or more. And sellers must report the amount forgiven on their tax returns using Form 982 (even if the income is excluded).

What if real estate doesn’t qualify for the principal residence exclusion? In most cases, short sellers will be taxed on the amount forgiven – unless they fall into the insolvency or bankruptcy categories or their promissory notes are non-recourse (loans in which the lender can only take the property back). In these cases, the seller will receive a 1099-S in the amount of the forgiven debt, based on the premise that the forgiven debt amounts to the sale price. For deeds in lieu of foreclosure, the seller should expect to receive either a 1099-C or a 1099-A (Acquisition or Abandonment of Secured Property).

In some states, mortgages taken out to buy principal residences are non-recourse by statute (California, for example), but Indiana isn’t one of them. Even in those states though, non-recourse loans can become recourse in cash-out refinances.

As always, sellers should consult their tax advisors for information specific to their circumstances.

- Morrie Erickson