I just received an email from my friend, Toni, who does short sale negotiations. Her question is as follows:

Q: What are the income tax consequences of selling your residence through a short sale?

A: Let me begin by explaining the basic concept of a short sale. Unfortunately for home owners, short sales are fairly common now. Five years ago, I'll bet most people had never heard the term. A short sale is simply a way to sell a property when the combined loans on the property are greater than the value of the property. The buyer negotiates a deal with the bank to pay off the mortgage(s) for less than face value. Then, the buyer works with the homeowner, gets the paperwork done, and buys the property.

The tax question is what happens to the homeowner if the total of the loans is more than what the homeowner paid for the house? Is there a gain to the homeowner or some other income that has to be recognized?

As with most tax questions, the answer is "it depends." It depends on whether the house is the principal residence of the homeowner. If not, it depends on whether the loan is recourse or nonrecourse and whether the owner is insolvement or bankrupt. Let's take these one at a time.

If this is the homeowner's principal residence and has been for 2 of the past 5 years, then the income from the bank reducing the debt should not be taxable, regardless of whether the debt is recourse or nonrecourse.

If not the homeowner's principal residence and the debt is recourse, the amount of debt reduction by the bank generally will be treated as ordinary income unless the homeowner is bankrupt or insolvent (liabilities greater than assets).

If the debt is nonrecourse, their will be gain to the homeowner as if they sold the house for an amount equal to the debt of the property.

As you might imagine, I'm giving the quick and dirty answer here. There are details I can't cover. So, before you enter into a short sale, I strongly recommend you sit down with your Tax Strategist and determine exactly the effect of your short sale on your tax liability.

Hopefully, this gives you some idea of what to expect. Call us at 866.467.5809 and set up an appointment for more information about a specific situation.

Warmest regards,

Tom