Short Sale Results in Tax Liability for Sellers

A court has considered whether borrowers owe taxes for the amount of debt discharged by a lender from a short sale of real estate.

George Stevens (“Taxpayer”) and his then-wife, Sharon Stevens (“Spouse”), purchased a residential property for investment purposes for $256,000. The property needed work, and so the plan was for the Stevens to put some money into the property and then either sell or rent it. The purchase was financed with a mortgage from Homecomings Financial (“Lender”).

Shortly after purchasing the property, the Stevens were unable to make a mortgage payment. In order to avoid foreclosure, the Stevens entered into a short sale agreement with a third party, with the approval of the Lender. A “short sale” occurs when the lender agrees to accept a sale price lower than the value of the loans secured by the property. The Lender imposed a number of conditions on the short sale, including limiting the amount of commissions and closing costs. The sale generated $181,461.31 in proceeds for the Lender.

Following the sale, the Lender sent the Taxpayer a Form 1099-C stating that it had canceled $74,494.96 in debt. A duplicate form was also sent to the Spouse (the couple had separated by this time). Neither the Spouse or the Taxpayer reported the discharged debt or property sale on their tax returns.

The Internal Revenue Service (“IRS”) found that the Taxpayer’s 2003 tax return had a deficiency of $21,323 and imposed penalties of $4,264 for the Taxpayer’s filing of an inaccurate return. The Taxpayer challenged this determination.

The United States Tax Court affirmed the IRS’s decision regarding the Taxpayer. In general, a taxpayer is required to include within his or her income all discharges from indebtedness. A sale of a property with a mortgage is generally treated as a sale upon which a gain or loss is realized. There are exceptions to this rule, such as when the sale resulting in the discharge of indebtedness is part of a bankruptcy case, or if the taxpayer is insolvent, or if the indebtedness is a qualified farm or business real estate debt.

While the Stevens claimed the property was for investment purposes, there was insufficient evidence for the court to evaluate whether the Taxpayer qualified for the business real estate exception. There also was insufficient evidence to determine whether the Lender intended to make a gift to the Taxpayer by forgiving the delinquency. Therefore, the court agreed that the difference between the short sale price and the loan amount, or $74,494.60, should be treated as ordinary income to both the Taxpayer and the Spouse as a discharge of indebtedness. Thus, the court upheld the IRS’s determination that the Taxpayer owed taxes on the discharge of indebtedness.

Next, the Taxpayer tried to argue that he did not owe a $4,264 penalty because he had a reasonable belief that the taxes were paid and acted in good faith, a defense a taxpayer can raise against the penalties. The Taxpayer argued that he assumed that the Spouse had paid the taxes for the discharge of indebtness because the tax bill had been mailed to her address. The court rejected this argument, as the Taxpayer acknowledged that he had also received the tax bill and there was no evidence that suggested the Spouse had paid the taxes. Therefore, the court affirmed the IRS’s imposition of a penalty.

In December 2007, President Bush signed into law the “Mortgage Forgiveness Debt Relief Act of 2007”. The new law applies to debt forgiven in 2007, 2008 or 2009. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, may qualify for this relief. In most cases, eligible homeowners only need to fill out a few lines on IRS Form 982.