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Beware Of Taxes In Distressed Sales

Ginny, last year was really hard. I got laid off, and we ended up short-selling our home. We thought we were fortunate because we didn’t end up with a foreclosure on our record, so we’ll be able to buy another home in two years instead of five. We knew the Internal Revenue Service wouldn’t tax us on it, under that temporary law.

But I just did my taxes and we actually owe the state more than $25,000 in income tax because of our short sale. We thought we were doing the right thing by not just letting the house go, but it looks like we’re going to be penalized for that after all. Hal S.

Hal, the reality is that when you are upside down and get laid off, there is simply no easy solution without implications. This is especially true if you decide or realize that you can no longer afford the place, even if you were offered a modified payment (which isn’t the easiest thing in the world to obtain, even if you could afford it).

Now, as with all tax topics, there are lots of exceptions and nuances and fact-specific details to the subject of taxation in foreclosure and short-sale cases, but I’m going to talk in general rules, here.

When you divest of your home through a foreclosure or short sale, the difference between what you owed on your home and the fair market value of the home (normally determined by what the lender is able to recoup through the foreclosure auction or short sale) is technically a debt that was forgiven, inasmuch as you are no longer responsible to pay it.

For tax purposes, a loan that is canceled transforms from a loan into income — and, as you know, income is taxable.

The taxing authorities generally call this form of mortgage forgiveness “cancellation of debt income,” or CODI. With respect to your federal tax liability, per the IRS Web site, “The Mortgage Debt Relief Act of 2007 generally allows taxpayers to exclude income from the discharge of debt on their principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure (in calendar years 2007-12), qualifies for the relief.”

However, each state has the power to conform their state tax laws to the federal rule, or not. In California, for example, the legislature has been passing a law that mirrors the federal Mortgage Debt Relief Act on a year-by-year basis. This year, however, this law has not yet passed. The politicos are currently wrangling over it, though, and there are strong indications that it will pass soon.

People in your situation are essentially faced with having to choose between the best of a set of bad options, and you might actually have done that. Letting your home go back to the lender through foreclosure would likely not have been any more advantageous, from a tax perspective, than your short sale. The “forgiven” mortgage debt is treated the same for tax purposes, whether it was forgiven through foreclosure, short sale or even a principal-reducing loan modification.

If there’s a mistake you’ve made, it’s the one you’re still making: trying to handle these matters on your own, without the advice of a local real estate attorney and tax expert.

People facing foreclosure are wise to consult with an attorney or certified public accountant (CPA) before things get too dire: They might be able to help you negotiate with the bank to minimize the tax and other impacts of losing or short-selling your home.

Even at this point in your process, it behooves you to have a tax professional do your taxes rather than try to do it yourself. The few hundred bucks you pay will undoubtedly be cheaper than paying all those taxes. A tax professional — a CPA or an enrolled agent (EA), ideally — can explore the entirety of the state and federal tax code and marshal all of its provisions to your advantage.

For example, even if your CODI is not tax-exempt under a temporary relief provision, you might qualify for an insolvency exemption from the tax if your debts outweigh the fair market value of your assets. But this is something that a tax pro would know that you as a do-it-yourself tax preparer might not..