Phantom Income Haunts Short Sale

We are upside down and are thinking about selling our home using a short sale. Our agent said that because we had refinanced our property twice, that we could have a problem with “phantom income.” She advised us to talk to our accountant. What does refinancing have to do with this and what is phantom income? — Janice E.

Janice, no matter what your financial circumstances are, it’s smart to talk to your CPA or tax attorney before placing any property on the market. For example, you might think that you can claim the $250,000 (for singles) or $500,000 (for couples) tax break on the sale of your primary residence. However, if you haven’t met all the qualifications in terms of the property being your primary residence, you could end up losing the deduction.

In your case, it’s a good thing that you have a well-informed Realtor who advised you to see an accountant first. When you purchase a home, the original loans that you place on the property are known as “purchase money” loans. Depending upon where you live and the type of instrument used to secure the mortgage, the lender may have limited options in terms of foreclosure on purchase money.

For example, in many states, the lenders cannot collect “deficiency judgments” on purchase-money loans. Their only recourse is to foreclose on the property. If you live in a state that allows deficiency judgments, the lender may be able to force you to sell other assets to pay off the debt. Putting it a little differently, if you own a property in a state that does not allow deficiency judgments, only the property that secures the note is at risk. If you live in a state that does allow deficiency judgments, the court can attach your other assets and order you to sell them to pay back the debt.

The situation becomes much more complicated when you refinance your property. Any loan that is made after the point of initial purchase is no longer considered to be purchase money. “Phantom income” occurs when you sell a property using a short sale and you do not pay off the entire amount of the loan. You can also create phantom income by giving what is known as a deed in lieu of foreclosure. (This means giving the keys back to the bank rather than going through the entire foreclosure process.) In either case, phantom income must be reported to the IRS and may be subject to taxation.

For example, assume that you placed a purchase-money mortgage of $150,000 on your property in 2002, then took out a home equity loan of $25,000 to do some remodeling in 2004, and then placed a third of $50,000 on the property to cover emergency medical costs in 2007.

In the example above, any amount over the $150,000 purchase-money loan could result in phantom income. The amount of phantom income is determined by how much debt relief you receive from the sale. The way the IRS looks at it, is that when you refinanced the property, you received the money. When you failed to pay it back to the lender in a short sale, that money then becomes taxable income. Since the money in the example above was used to improve the property and to pay for medical expenses, the owner may be eligible to deduct part of those expenses against any phantom income that results from a sale. On the other hand, if you are someone who has refinanced your property and spent that money to pay off your credit cards or to buy a car, the probability is that your phantom income will be taxed.

For some people, going through foreclosure may be a better choice. Before you decide to do anything with your property, it is absolutely imperative that you discuss the situation with your CPA or tax attorney to find out the potential consequences of any decision that you may make.