Short Sale Tax Break on Deficiencies May Be Ending December 31, 2012

One of the more frequent questions asked by a homeowner considering a short sale to cure foreclosure is whether the homeowner will be taxed on this forgiveness.

Some background: Typically a short sale occurs when the property is no longer worth the amount that the lender is suing you in foreclosure for. (ie you are being sued for $300,000 and your home is only currently worth $150,000).  In this case, you wish to sell the property and think you can do so for around $150,000.  You, or your lawyer, will be asking the bank for forgiveness off the debt above the $150,000 in our example, thus releasing you from any money liability to your lender and “walking away clean.”

But there is an issue with this.  What happens to that forgiveness in terms of your taxes?  Usually, forgiveness of any type of debt is considered income to you, and thus taxable.  In our example above, the homeowner would be liable for taxes on $150,000 in extra income. This means if you make a yearly salary of $50,000, next year you would be taxed on $200,000 in total income, and at a much higher tax bracket.

The Mortgage Forgiveness Debt Relief Act of 2007 was made to address this issue Act stated that in the case of debt forgiveness for a primary residence, this income would NOT be taxable.  thus, in our example above, the $150,000 would to be taxable and would vanish “into thin air.”  This Act led to a surge in short sales, and short sales have tripled in the past 2 years.  Short sales have also spiked in recent months.  The National Association of Realtors reports that “Short sales from borrowers behind on their payments jumped 22 percent over last year for the three months ending Sept. 30, RealtyTrac reports.    Short sales also jumped 17 percent among borrowers who were still current on their payments.” Why?

Because the Mortgage Forgiveness Debt Relief Act of 2007 is set to expire on December 31, 2012 and has yet to be extended.  Thus, this would be devastating to homeowners trying to walk away from their underwater homes.  Any house short sold after January 1, 2013 would have its forgiven debt taxed as income to the homeowners 2013 tax returns, causing thousands of dollars of extra taxes due.

Short sales will come to a halt as no reasonable homeowner will want to pay the taxes on 6 figures of extra income next year.  Theoretically, this would greatly slow the housing recovery as homeowners would be much more hesitant to sell rather than just stay in their property as long as possible until the bank forces them out.  Foreclosures would clog up the courts more than they already are because people are going to fight instead of trying to work something out with the banks.

There will also likely be a large spike in Chapter 7 bankruptcy filings because you can eliminate all of the mortgage debt (and tax liability) in a bankruptcy.  

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