Foreclosure or Short Sale Potential Tax Consequences

By: Owner – Mark S. O’Connell, CPA, LLC Professional Tax Planning and Preparation

More and more Americans are finding themselves in a position they hoped would never be. Financial problems or life changes coupled with owning homes that are worth far less than the mortgages that secure them have caused many to decide the only option is to sell their homes for less than they owe (a Short sale) or to walk away all together and let their homes go into foreclosure.

One thing many of these individuals are not aware of as they analyze there situation: The potentially significant tax consequences associated with the debt forgiven or possible capital gain in either a short sale or a foreclosure. The following is an overview of some of the important tax implications anyone considering a short sale or foreclosure should be aware of.

Potential Capital Gain on Sale:
This is less of an issue with primary residence sales but can really cause issues with highly leveraged investment properties and so is worth noting here.  Your tax basis in your property is what you purchased your home for plus any major capital improvements less depreciation expense taken, if applicable. In a short sale the purchase price is always less than your mortgage debt outstanding but it can still be higher than your original purchase price. To the extent the sales price exceeds your tax basis (purchase price plus improvements minus depreciation) there will be a taxable gain. There is a common misconception that somehow your mortgage balance is a factor in calculating the basis of your property – it simply does not factor into basis calculations in any way! With primary residence transactions this gain is excluded up to $250,000 (or $500,000 Married Filing Joint) if homeowner has lived in the home, as their primary residence, 2 of previous 5 years. Because of this §121 Gain Exclusion homeowners often side step this potential hit. That said no exclusion exists for investment properties, second homes or primary residences that do not qualify for 2 of 5 year rule. Although the scope is limited this is a real issue that we are seeing show up and should be thought through before making any final decisions.

DDI Debt Discharge Income:
DDI is the big one for individuals to understand. Individuals must understand how these rules pertain to their specific situation before making any final decisions on property transactions.

In 2007 congress passed a bill allowing up to $2,000,000 of DDI from mortgage debt to be tax free when debt was taken out to acquire, improve or build an individual’s principal residence. This does not include debt created through a cash-out refinance or home equity line that was not used to improve your principal residence. Taxpayers must be prepared to trace any increase in principal during the period of homeownership to building or improvements or those portions of the overall mortgage debt will NOT be tax free. If the taxpayer has potential exposure after this analysis there may still be hope for tax free treatment. If the taxpayer is going through bankruptcy when the debt discharge transaction occurs it will be tax free OR if the taxpayer can show they are insolvent they will be able to treat the DDI as tax free income. Also worth noting is that the 2007 provision does not include investment properties or second homes making DDI associated with these properties taxable unless you are going through bankruptcy or are insolvent. Insolvency calculations can be subjective and complicated so taxpayers should consult a tax professional before attempting to go down that path.

DDI Example: Mr. D purchased a $300,000 home in 2003 and took out a $240,000 interest only mortgage in order to acquire this home. In 2006 Mr. D’s home was appraised at $400,000 and he did a refinance to lower his rate and take some cash out with new principal balance of $300,000. He used the $60,000 he received at closing to buy a new boat and car. Later in 2006, Mr. D took out a HELOC of $100,000 to invest in a business opportunity bringing total debt on this property to $400,000 (100% of 2006 appraised value). He assumed his house would be worth $500,000 in a couple years and he would again have 20% equity. In early 2009, Mr. D lost his job and fell behind on his monthly mortgage payments. He realized his house was now worth closer to $250,000 when his neighbor sold her house for that amount. Then after 9 months without finding work he was so far behind on his payments and so frustrated that his once $400,000 home was now worth closer to $250,000 that he walked away from his property to rent an apartment. When he went to his accountant get his taxes done for 2009 he was told he had $160,000 of debt forgiveness income to claim on his return from the $60,000 taken on refinance and the $100,000 from HELOC, neither of which was used to improve his property. This DDI caused a $50,000 IRS bill that MR. D had no idea was coming. Mr. D was not in bankruptcy and although cash was tight he had assets on his personal balance sheet making it impossible to claim insolvency. In the end this debt forgiveness income was taxable income and he was on the hook for a significant tax bill.

Short Sale Gain Example: Using the same facts as above except for this was Mr. D’s lake home and not his primary residence plus rather than foreclosure he made Short Sale for $350,000. Mr. D is going to have $50,000 of DDI when he is off the hook for $50,000 of total $400,000 of mortgage debt. PLUS he will have a capital gain on the sale of this property calculated as follows.

Proceeds: $350,000
Tax Basis: ($300,000) Purchase Price – no major capital improvements
Gain on Sale: $50,000

Although he nets zero and has $50,000 taxable debt forgiveness income his second home still creates a taxable capital gain of $50,000. Total income to report on his 2009 tax return related to disposal of second home is $100,000.

Whether it is you, a client of yours, or a personal contact of yours make sure people forced to make these tough decisions consult a tax professional in advance. Most people will not have these issues given the taxpayer friendly legislation that has passed but some will start to take a sigh of relief only to have IRS piling on new financial problems immediately following.