IRS Tax Consequences for Short Sales Vs. Foreclosures
In the eyes of the IRS in many cases a short sale is treated differently than a foreclosure. Depending on the laws for a state, the IRS tax consequences to a home owner that experiences foreclosure can be moderate to severe. A short sale is a settlement option between the home owner and the lender to sell the home for less than the mortgage balance, while a foreclosure is a bank repossession of a property.
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Recourse vs. Non-recourse
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A recourse debt is a debt that the taxpayer is personally liable for. In this scenario the lender can pursue a borrower for any amount that is a deficient difference between the amount that the property was sold for and the balance carried on the mortgage. This amount is treated as income for the taxpayer, from which the IRS will send a income statement from the sale and hold the taxpayer liable. This happens quite often in a foreclosure.
A non-recourse debt saves the taxpayer from income tax liability on the deficiency amount. In these cases the taxpayer will not receive an income statement and will not owe any additional taxes. This is more common with a short sale.
Mortgage Forgiveness Debt Relief Act of 2007
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The Mortgage and Forgiveness Debt Relief Act of 2007 was designed to help homeowners with post tax liability in a short sale or deed in lieu of foreclosure. This law is only applicable to short sales and deeds in lieu of foreclosure for tax years 2007, 2008 and 2009. This act protects home owners from tax liability on the deficiency amount owed on a primary residence. However, home equity loans, secondary property loans, or investment properties do not qualify for tax relief and will still be subject to income tax liability.
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Short Sale Benefits
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When it comes to income tax liability, short sales are a much better alternative to foreclosure. Foreclosures will decrease a consumer's credit score more substantially than a short sale, and will be subject to income tax liability as well as collection activity from the lender on a mortgage balance. When considering foreclosure alternatives should you become unable to remain in a home, consider a short sale or deed in lieu of foreclosure as opposed to letting the home fall into foreclosure.
Bankruptcy
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Filing a Chapter 7 or Chapter 13 bankruptcy can wipe out deficiency balances from a lender, and can negate the income tax liability as well as mortgage collection activity in the event of a short sale or a foreclosure. Since a bankruptcy proves financial insolvency, it protects the consumer against tax liability.
Expert Insight
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As with anything having to do with the IRS it is wise to consult with a certified public accountant to discuss the potential tax liability in the event of short sales, deeds in lieu of foreclosure and foreclosure situations. An accountant can educate you on which tax scenario would be best in your own financial situation, and provide guidance when selecting the best way to handle the foreclosure activity on any property you own.
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References
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