Tax Ramifications of Foreclosures and Short Sales

The IRS has a unique way of getting into our back pockets even if we are facing financial challenges. If you transfer title on your home, no matter whether it is voluntary or forced...you have "sold your home". You may have transferred it voluntarily through through a warranty deed or a grant deed, or you may have transferred it involuntarily through foreclosure. Under the tax code, you might be subject to taxes even if you lost money on the sale either by "selling short" or being "foreclosed" upon.

This seems really unfair...and to make matters worse, you might not even find out aoubt your tax ramification until you receive a 1099 - A in the mail at the end of the year.

Sellers who have owned their homes for lengthy periods of time most often will appreciate a "capital gain" during the sale of their property. However sellers of real estate who acquired them within say a time frame of 2-3 years, often will incur a net loss at the time of sale. Even if they do not lose value on the property, there are closing costs to incur such as real estate, escrow, and title fees that can be significant. It does not matter the seller's position...they cannot deduct the losses...no matter what forced them to sell.

Besides the problems for sellers of personal residences, investors are feeling this pain as well. This is true, especially in markets where real estate was purchased with the intent to "flip" within a short period of time. The market changed, they are stuck with real estate that is declining in value...rents do not cover the monthly expenses...they are forced to make a hard choice. Do they hold on or let the property go and face possible tax ramifications...

Sellers can offset their capital losses against capital gains under the current tax code. However if there are no gains, there is a yearly cap in the amount they can write off their taxes. It is $3000.00 ($1500.00 for married couples filing separately) on the amount of losses that can be offset against their "ordinary income".

The IRS has specific rules for foreclosures and short sales. These can be painful and severe, especially for the homeowner or investor who has already incurred significant expense and losses due to losing their property.

I am going to give you an example...Mr. Jones purchase a home for $200,000. He puts 10% down and takes out a mortgage for $180,000. Over the next 18 mos he manages to pay down his mortgage to $175,000, then he becomes very ill...loses his job and incurs significant medical expenses. He defaults on his mortgage payments and is forced to give the home to the bank. The IRS code treats this as a sale. The real estate market in this area has declined due to a major manufacturing plant closing its doors. The current market value of similar homes down the street has fallen to $140,000. Mr Jones incurs a $60,000 loss that cannot be deducted. His house is sold at the auction for $140,000. He gets a "1099 - A" at the end of the year. It indicates the foreclosure bid price of $140,000, the amount of Mr Jones' debt of $175,000, and his personal tax liability of $35,000. This is taxed at the rate of "ordinary income"...the same as salaries and tips. This is a typical problem seen when the homeowner is personally liable for the debt.

There is another type of scenario where the person taking out the loan is not "personally liable" for the loan...the tax ramifications are not so severe under the code. According to Kleinrock Publishing, "the IRS says sellers who are not personally liable for a debt will realize an amount that includes the full canceled debt, even if the value of the property that is security for the debt is less, which can be offset depending on your adjusted basis in the property". For example, Mr. Jones purchases a home for $200,000. Mr Jones puts 10% down and takes out a mortgage for $180,000. He pays down the mortgage to $175,000 then stops making payments. The bank forecloses on the loan for $175,000. The value has dropped to $150,000. The property sells for $150,000 at the auction. Mr. Smith realizes an amount of $175,000 on the foreclosure, but has an adjusted basis of $180,000 due to a "casualty loss" of $5,000. He owes no tax. This is a rare scenario, as banks and savvy lenders almost always require the individual who takes out the loan to sign "personally" for the note.

The tax code is extremely confusing to navigate under normal circumstances, let alone when you are facing challenges and are under significant stress. The above examples are for informational purposes only and should not be taken as "tax advice". If you are considering a short sale process or foreclosure, you should always consult a qualified CPA and tax attorney to get accurate, real world advise. Make sure you completely understand your options. Do your planning ahead of time....DO NOT wait until the last minute. Consider loan modification. This is a very viable option. We have solutions and can help...contact me directly for a free confidential consultation.