<%@LANGUAGE="VBSCRIPT" CODEPAGE="1252"%> Tax Consequences of a "Short Sale" of Real Estate vs. Foreclosure
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Tax Consequences of a "Short Sale" of
Real Estate vs. Foreclosure

   
         
   

The United States is now seeing the effects of tightening mortgage credit. With interest rates increasing for adjustable rate mortgages. Borrowers in default are either trying to "walk away" from their homes allowing them to be foreclosed or are making "short sales".

A "short sale" is selling the home for less than the current mortgage balance and trying to get the lender to forgive the unpaid balance.

A reason for debtors to consider a "short sale" instead of a foreclosure is to try to protect their credit history.

An important consideration in the results of a foreclosure is whether the debt is "recourse" or "nonrecourse". If the debt is "recourse", the debtor is personally liable for the debt. If the debt is "nonrecourse", the debt is only secured by the property, and the debtor is not personally liable for the balance.

You might need to consult with an attorney to determine the status of your mortgage. In California, most mortgages that are used to purchase a residence are nonrecourse, but mortgages from refinancing a previous mortgage are usually recourse. When a nonrecourse mortgage is foreclosed, the property is treated as being sold for the balance of the mortgage. (G. Hammel, SCt, 41-1 USTC ¶ 9169) This is important because the gain from a foreclosure of a principal residence may be eligible for the $250,000 ($500,000 for jointly-owned marital property) exclusion.

   
   

 

 

For example, for foreclosure of a nonrecourse debt,

Nonrecourse debt $500,000
Tax basis (cost to determine tax gain or loss)   300,000
Gain $200,000

If the holding period requirements are met and the residence was a principal residence the above gain would be tax-free.

For recourse debt, the debt is only satisfied up to the fair market value of the property. There is a sale up to that amount. If the lender forgives the balance of the mortgage, there is cancellation of debt income, which is taxed as ordinary income. (Regulations § 1.61-12.)

 

For example, for foreclosure of a recourse debt,

Recourse debt $500,000
Fair market value   450,000
Cancellation of debt (ordinary income) $ 50,000

Fair market value $450,000
Tax basis   300,000
Gain $150,000

Again, if the holding period requirements are met and the residence was a principal residence the above gain would be tax-free, but the cancellation of debt would generally be taxable as ordinary income.

What happens with a "short sale"? Since any debt cancellation (recourse or nonrecourse) is not being satisfied with the surrender of the property, any debt not satisfied with the sale proceeds would be taxable as cancellation of debt income. (Rev. Rul. 92-99, 1992-2 CB 518.)

Therefore, the tax consequences would be similar to the "recourse debt" example, above. There might also be legal concerns about whether the lender would consent to the transaction and whether (for recourse debt) the lender would in fact forgive the debt.

 

For example, for a short sale,

Net sale proceeds $450,000
Tax basis   300,000
Gain $150,000

Debt (recourse or nonrecourse) $500,000
Pay off using net sale proceeds   450,000
Cancellation of debt (ordinary income) $ 50,000

Therefore, debtors with nonrecourse debt and who qualify for the exclusion from income of the gain from the sale of a principal residence are probably better off letting their home be foreclosed than making a "short sale".

The cancellation of debt income may not be taxable if the debtor is insolvent or has the debt discharged in bankruptcy. (Internal Revenue Code Sections 108(a)(1)(A) and 108(a)(1)(B).) With recent changes in the federal bankruptcy laws, it is much harder for individuals to file bankruptcy than before the changes.

What if the fair market value of the home has dropped after purchase?

 

Example - Non-recourse foreclosure

Mortgage balance $500,000
Tax basis   700,000
Loss -$200,000

(The fair market value of the property is disregarded for a non-recourse mortgage.)

If this is a principal residence, the loss is a non-deductible personal loss.

 

Example – Recourse foreclosure

Mortgage balance $500,000
Fair market value   450,000
Cancellation of debt income $ 50,000

Fair market value $450,000
Tax basis   700,000
Loss (for personal residence, non-deductible) -$250,000

Example – Short Sale

Mortgage balance $500,000
Net sale proceeds applied to pay off mortgage   450,000
Cancellation of debt income $ 50,000

Net sale proceeds $450,000
Tax basis   700,000
Loss (for personal residence, non-deductible) -$250,000

So, the tax consequences for a nonrecourse mortgage still favor foreclosure over a short sale when the value of the property has dropped and the fair market value of the property is less than the mortgage balance. In the above example, $50,000 of cancellation of debt income would be avoided with a foreclosure compared to a "short sale." However, if you have a recourse mortgage, making a "short sale" could save your credit without serious additional tax consequences.

IRS Circular 230 Disclosure: As required by U.S. Treasury Regulations, you are hereby advised that any written tax advice contained on this website was not written or intended to be used (and cannot be used) by any taxpayer for the purpose of avoiding penalties that may be imposed under the U.S. Internal Revenue Code.

   
         
         



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