Tax Implications With a Short Sale
A short sale occurs when a property is sold to a third party for less than the balance owned on the mortgage. For example, a homeowner may still owe $150,000 on a mortgage but could sell the property for $100,000 if the lender agrees. Short sales usually occur when properties are in pre-foreclosure. Homeowners may face unexpected short sale tax implications as a result of the transaction.
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Taxable Gains
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Although the short sale usually results in a net loss or breaking even for the homeowner, he could still be charged with a taxable gain from the sell in certain situations. For instance, if the home was purchased for $250,000 originally but sells to the third party for $300,000 because of an increase in the property's market value then that equals a $50,000 gain for the homeowner in the eyes of the Internal Revenue Service (IRS) even if $350,000 in first and second mortgages were owed on the property at the time of the sale.
Debt Discharge Income
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During a short sale, the lender accepts less that the outstanding debt in exchange for the title to the property. The forgiven debt is considered taxable income in the Federal and state tax codes. For example, a family in San Francisco ended up owing California $38,000 in taxes because the lender forgave more than $400,000 of their mortgage in a short sale.
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Mortgage Forgiveness Debt Relief Act
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Under the Mortgage Forgiveness Debt Relief Act passed in 2007, up to $2 million in forgiven debt for the principal residence does not have to be counted on the Federal income tax. However, the forgiveness only counts toward debt incurred for the purchase or improvement of the principal residence. Loans for vacation or secondary properties or home equity loans used to pay off credit cards or make other purchases do not qualify for this exemption. The Act covers debt discharged between 2007 and 2012.
Insolvency And DDI
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If the debt discharge income (DDI) is accrued when the homeowner is insolvent, meaning her debts are higher than their assets, the amount does not have to be claimed as income, regardless of how the forgiven debt was used originally. Homeowners in bankruptcy at the time of earning the DDI also do not have to pay taxes on the amount.
Tax Losses
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In some cases, the short sale will cause the homeowner to lose money even from the original investment in the property. For instance, if the property was purchased for $200,000 but sold in a short sale for $150,000, the homeowner has lost $50,000. However, the loss cannot be claimed on the taxes. Losses on real estate can only be claimed on business or investment property not the principal residence.
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References
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