Here is a question from my good friend, Melissa, that I am sure is on the mind of many people these days. Many of you are unloading properties that are "under water" (the mortgage is higher than the value of the property) via a short sale. In a short sale, the buyer purchases the property and shorts the mortgage lender. In other words, the mortgage lender agrees to take less than the face amount of the mortgage in order to get rid of the property. There can be serious tax consequences to the seller on this transaction.
Q: If I have to do a short sale on a property, I get a 1099 from the government, which is considered forgiveness of debt. That’s taxable, but there are some ways with Obama’s recovery plans that stay that, right?
A: Actually, you will receive a 1099 from the lender. And yes, it's considered forgiveness of indebtedness. And generally, forgiveness of indebtedness is taxable income. There are some possible ways out of this.
First, if you are insolvent, you don't have to recognize the income to the extent of your insolvency. Insolvent means you have liabilities (outside of those in the short sale) that are higher than the value of all of your assets. For example, if you have debt of $600,000 and the value of all of your assets is $500,000, then you are insolvent to the extent of $100,000 and you do not have to recognize the first $100,000 of debt forgiveness income.
Second, if you are bankrupt, then you don't have to recognize the income. Both of these first two exceptions to taxation have been part of the law for many, many years.
Third, President Bush (not Obama), added a provision that allows you to avoid taxability if the short sale is on your primary residence.
There is one provision for investors to avoid income. If the discharge is of considered to be qualified real property business indebtedness, then the income may be excluded. The one other advantage an investor can get is if the loan is nonrecourse (no personal liability). In that case, the forgiveness is treated as a sale of the property and you get to recognize capital gain instead of ordinary income.
If you are in this situation, I strongly recommend you sit down with your tax coach and go over the numbers to determine whether you are insolvent and what the precise income tax consequences of the short sale will be to you.
The tax liability can be huge in a short sale, so be sure to get all of your facts straight and understand the rules before you go through with the short sale. When you do this, you can make a better decision and know the consequences of the sale before it happens.
Warmest regards,
Tom