Short Sales or Foreclosures
Good news! With the new cancelation of debt and debt relief act of 2007, you don't have to worry about complicated calculations in order to figure your ordinary income tax from the forgiveness of debt due. The sale of your main home due to foreclosure or repossession.
You may have a taxable gain if the gain is more than $250,000.00 if you are single or if your gain is more than $500,000.00 and you are married. In other words, your otherwise taxable gain may be tax exempt if the gain amount is $250,000 or less if you are single and $500,000.00 or less if you are married and your home qualifies as your main residence. But realistically, the reason you are losing the home to a short sale is because you don't have equity, therefore, most likely no capital gain.
In the state of California most loans that are secured by a main residence are non-recourse loans and are not subject to the canceled debt rules. They are however subject to capital gain tax due to foreclosure or repossession but only if the outstanding loan balance exceeds the adjusted basis by the amounts mentioned above. Keep in mind that your property must qualify as your main home at the time of the transfer in order to qualify as a tax exempt sale. Other conditions must be met as per I.R.S section 121. Please contact us for more details. Again, if you are losing your home due to lack of equity, most likely the balance owed on the property will not be subject to capital gain.
The adjusted basis should not be confused with the fair market value. The fair market value is the present value of the property at the time of the appraisal. The adjusted basis is what you originally paid for the property plus improvements minus depreciation (if any). Improvements are generally additions to the property that will increase its value or additions that have a year or more of useful life. Depreciation is the wear and tear of the property deducted yearly depending on the cost of the dwelling, not the land. Land is not depreciable. Depreciation only applies to assets used in businesses like rental property or commercial buildings and equipment used in business.
In a short sale transaction, the outstanding loan balance is usually larger than the adjusted basis and usually larger than the fair market value. This is the reason you are doing the short sale, because you don't have equity on your home. When you sell your property through a short sale transaction, the lender will send you a 1099-A form or a 1099-C form depending on if the loan is a recourse loan or a non-recourse loan.
The fair market value is not taken in consideration on non-recourse loans or loans where you are not personally liable for the loan. It is taken in consideration however when the loan is a recourse loan or a loan where you are personally liable. On recourse loans, you may have ordinary income from a canceled debt in addition to your regular capital gain or loss from your short sale transaction. Recourse loans are generally not used on mortgages that are secured by a main residence. They are more frequently used on car loans, credit card debt, and other signature type loans.
The Worksheet for Foreclosures and Repossessions can still help you calculate both the income from canceled debt from a recourse loan as well as the gain or loss from foreclosure or repossession from a non-recourse loans.
In the case you end up with a gain, this gain may still be exempt or minimized even if your property does not qualify as your main residence. This is true if you sold your home due to an unforeseen reason such as a job transfer, unemployment, divorce, or health reasons. Other exemptions include bankruptcy and financial insolvency.
Some banks will try to talk the borrower into signing an addendum to convert the non-recourse loan to a recourse loan in order to mitigate the lender's loss but it is not in the borrower's best interest to change the contract because this may increase their tax liability and or their financial obligation to the bank.
The most important thing you need to know is if your loan is a non-recourse loan or a recourse loan in order to determine if your short sale transaction is taxable or non-taxable. If your loan is a non-recourse, you will not have ordinary income from cancelation of debt. However, you may have capital gain or loss depending on how much you owed to the lender at the time of the foreclosure or transfer and how much you purchased the property, in addition to any improvements. This capital gain may or may not be taxable depending on the use of your home and other seen circumstances include multiple births from same pregnancy, change of employment, natural disasters, and other involuntary transfers or involuntary sales. Other situations to consider that may make help you exclude your otherwise taxable gain are:
1. Most short sales are due to financial insolvency from the borrower. The I.R.S. does not recognize taxable gain if you are financial insolvent or bankrupt. See I.R.S. pub 908.
2. If you owned and used your home as your main residence 2 out of the last 5 years, you may qualify for a taxable gain exclusion up to $250,000 if single and $500,000 if married.
3. If your sale was due to change of employment, health reasons, and other unforeseen reasons, you may qualify to exclude your taxable gain if you have any. Please contact us for more details.
The problem is that by now, the loan balance is higher, realizing a larger sale amount to the home owner and possibly a larger taxable gain. The scam artist walks away with some money collected form the tenant’s rent, the tenants get evicted, and the original home owner remains with foreclosure on his record because the loan was always in his name.
REVIEW: When you short sale your home you have a sale period. The short sale of a home is treated the same way as a foreclosure, deed in lieu of foreclosure, repossession or a conventional sale for tax purposes. The difference is that on a short sale, foreclosure and deed in lieu of foreclosure the canceled debt is considered to be the selling price or the realized amount for gain or loss calculation purpose. The nature of the loan, non-recourse, or recourse are the primary factors to determine if the sale has a gain.
Secondary factors like the use of the home or special unforeseen circumstances determine whether the gain is taxable or not. Contrary to popular belief, the fact that the home was sold on a short sale does not determine if the gain is taxable or non-taxable. It is the use of the home and the nature of the loan that determines the tax consequences.
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