Is my short sale taxable? this is the question of the year and most likely for the next 3 years.
Why? Because of the Real Estate Market downturn, the short sale transactions are increasing and most likely will continue to increase for the next two years, having tax consequences for the next three years.
What is a short sale? It is a compromised sale between the homeowner, the existing lender and the new buyer. The seller owes more than what the house is worth thus the lender has to discount the existing loan canceling part of the debt in order to allow the seller to close escrow without the seller having to put money out of his pocket to close escrow.
Generally the transfer of foreclosed property or the sale of a short sale is treated the same as the sale of the taxpayer's main residence for tax purposes. The only difference is that in a short sale, the amount of the canceled debt is treated as the sale amount. Contrary to the popular belief that most short sales are taxable. Most short sales are not taxable.
Click here for most recent approved short sales guidelines effective April 2010 Facts:
1.-Your short sale transaction may qualify as your main residence and a capital gain tax exclusion as per IRS code 121
2.-Because of your financial hardship you may qualify to exclude the ordinary income due to financial insolvency and or bankruptcy as per IRS PUB 908 and PUB 544
3.-Other acceptable hardships that will help you exclude your capital gain from being taxed are: unemployment, employment change, divorce, health, multiple births in same year etc. as per IRS code 121 and IRS pub 523.
To simplify this. I have created a short sale gain estimator that will give you a very good estimate of the tax consequences of your short sale transaction. Sources, pub 523 and pub 544 of the irs codes.
It is important for the seller to know if their loan is a non recourse loan or a recourse loan.
Non recourse loans in California are secured by the real estate property and the borrower/seller is not personally liable for the loan. You do not have ordinary income from the short sale of a property with a non-recourse loan. You may however have capital gain that may be excluded if your property meets the rules for a primary residence held and used as a main residence for 2 years out of the last 5 years prior to the sale or transfer. Recourse loans on the other hand may hold the borrower personally liable for the balance due even if the property is foreclosed and sells for less than the amount owed on the property.
On recourse loans the borrower may have ordinary income in addition to capital gain due to the short sale transaction. Why ordinary income? Because the difference of the canceled debt and the fair market values is considered to be a loss to the lender and a gain to the seller/borrower. The reason you may have capital gain taxes as well is because the adjusted basis of the property may be less than the foreclosed or canceled debt amount. This happens when the borrower refinances or gets a line of credit.
Fortunately in the state of California, most real estate loans are non-recourse loan reducing the financial risk to the borrower and passing it to the lender. For tax purposes short sales, foreclosures, and repossessions are all treated as conventional sales where the gain is subject to capital gain taxes. in a short sale the amount of the canceled debt is to be considered as the selling price or the realized amount. If the property foreclosed or sold in a short sale qualifies as the seller's main residence for at least 2 years, it may qualify to be excluded from taxable gain as per IRS CODE 121.
This may sound a little confusing. This is why I have simplified and included a Foreclosure and Repossessions worksheet below for non-recourse loans and recourse loans.
Example no. 1 for non-recourse loans
Table 1-2. Worksheet for Foreclosures and Repossessions
| Part 1. Figure your income from cancelation of debt. (Note: If you are not personally liable for the debt, you do not have income from cancelation of debt. Skip Part 1 and go to Part 2.) | |
| 1. Enter the outstanding balance immediately before the transfer of the property less the amount that your remain liable for after the. The result should be almost always the same amount of the debt canceled by the lender | $312,000 |
| 2. Enter the fair market value of the transferred property | $265,000 |
| 3.Income from cancelation of debt.* Subtract line 2 from line 1. If less than zero, enter zero | $47,000 |
| Part 2. Figure your gain or loss from foreclosure or repossession. | |
| 4. Enter the smaller of line 1 or line 2. Also include any proceeds you received from the foreclosure sale. (If you are not personally liable for the debt, enter the amount of the outstanding loan balance before the transfer of the property.) | $312,000.00 |
| 5. Enter the adjusted basis of the transferred property | $308,000.00 |
| 6. Gain or loss from foreclosure or repossession. Subtract line 5 from line 4 | $4000.00 |
| * The income may not be taxable. See Cancelation of debt |
The income from cancelation of debt on box 3 of part 1 is ignored because the loan is a no-recourse loan. However, the seller has capital gain income on box 6 of part 2.
This gain may excluded from taxable income if the property qualifies as the taxpayers principal residence and it was used as his main home for at least 2 years of the past 5 years prior to the sale or transfer. IRS code section 121
Example no. 2 for recourse loans
Table 1-2. Worksheet for Foreclosures and Repossessions
| Part 1. Figure your income from cancelation of debt. (Note: If you are not personally liable for the debt, you do not have income from cancelation of debt. Skip Part 1 and go to Part 2.) | |
| 1. Enter the amount of debt canceled by the transfer of property | $312,000 |
| 2. Enter the fair market value of the transferred property | $265,000 |
| 3.Income from cancelation of debt.* Subtract line 2 from line 1. If less than zero, enter zero | $47,000 |
| Part 2. Figure your gain or loss from foreclosure or repossession. | |
| 4. Enter the smaller of line 1 or line 2. Also include any proceeds you received from the foreclosure sale. (If you are not personally liable for the debt, enter the amount of debt canceled by the transfer of property.) |
$265,000.00 |
| 5. Enter the adjusted basis of the transferred property | $308,000.00 |
| 6. Gain or loss from foreclosure or repossession. Subtract line 5 from line 4 | <$43000.00> |
| * The income may not be taxable. See Cancelation of debt |
Notice that you ended up with ordinary income from canceled debt in a recourse loan but a capital loss which by the way is a non deductible loss due to a personal loss and not a business loss. Tip: If you anticipate a short sale you may convert the residential property to a rental property and write off the loss.
Tip: Your ordinary income from box number 3, of part 1 of the table above may be excluded from income if you were financial insolvent or bankrupt. IRS SECTION CODE121
Resources: franchise tax board summary analysis of amended bill regarding short sales
If you are still confused go to my automated short sale calulator and enter the amonts
Taken from publication irs 523 Other Dispositions
The following rules apply to foreclosures and repossessions, abandonment, trades, and transfers to a spouse. Short sales are considered abandonment and are treated as repossessions, for gain or loss calculations purposes.
Foreclosure or repossession. If your home was foreclosed on or repossessed, you have a sale.
You figure the gain or loss from the sale in generally the same way as gain or loss from any sale. But the selling price of your home used to figure the amount of your gain or loss depends, in part, on whether you were personally liable for repaying the debt secured by the home, as shown in the following chart.
|
IF you were... |
THEN your selling price includes... |
|
not personally liable for the debt |
the full amount of debt canceled by the foreclosure or repossession. Or the short sale amount |
|
personally liable for the debt |
the amount of canceled debt up to the home's fair market value. You may also have ordinary income, as explained next. |
Ordinary income. If you were personally liable for the canceled debt, you may have ordinary income in addition to any gain or loss. If the canceled debt is more than the home's fair market value, you have ordinary income equal to the difference. Report that income on Form 1040, line 21, or on Form 1040NR, line 21. However, the income from cancelation of debt is not taxed to you if the cancelation is intended as a gift, or if you are insolvent or bankrupt. For more information on insolvency or bankruptcy, see Publication 908, Bankruptcy Tax Guide.
Form 1099-A and Form 1099-C. Generally, you will receive Form 1099-A, Acquisition or Abandonment of Secured Property, from your lender. This form will have the information you need to determine the amount of your gain or loss and any ordinary income from cancelations of debt. If your debt is canceled, you may receive Form 1099-C, Cancelation of Debt.
More information. If part of your home is used for business or rental purposes, see Foreclosures and Repossessions in chapter 1 of Publication 544 for more information. Publication 544 has examples of how to figure gain or loss on a foreclosure o
What is “nonrecourse” debt?
Under California law, a debt is considered “nonrecourse” when a loan is made under either one of the following two circumstances:
(1) When the loan is made to purchase a one-to-four unit property and the borrower intends to occupy at least one of the units, or
(2) When the seller carries back financing for all or a portion of the purchase price of any real property.
(Cal. Code Civ. Proc. § 580(b.)(d)
In the event of default by the borrower, the lender, or financing seller, is restricted to recovering the property with no right to proceed against the borrower for any deficiency.
What is “recourse” debt?
Under California law, a “recourse” debt is one in which neither of the two exemptions in Question 4 occurs.
Examples of recourse debt are refinances of existing mortgages, home improvement loans, equity lines of credit, and loans, other than seller financing, securing a debt for purchase of property that is not an owner-occupied one-to-four unit property. The lender is not limited to taking the property back and the borrower may be personally liable on the debt. If the lender chooses to foreclose using a trustee’s sale, then the lender waives the right to go after the borrower for the deficiency despite the fact that the loan was a recourse debt.
