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More on short sales and tax exempt gain
Forgiveness of Non-recourse loans may be tax free
By
Ace Tax and Realty, Armado Hurtado
Generally, the IRS income tax code provides lots of credits for homeowners. Your mortgage interest is deductible, which reduces your tax bill. Interest on a home equity line of credit is also deductible; it reduces the cost of borrowing against your home to put in granite countertops. And if you've lived in your home for at least two years, you can sell it and pocket $250,000 of the profit if you are single and $500,000 if you're married filing joint-- tax-free. IRS CODE 121(B)(3) This exclusion replaced the old rollover exclusion code sec 1034 which unfortunaly many people out there still beleive that by purchasing another home, they will elilminate capital gain taxes. You don't have to buy another home to eliminate taxes.
You may postpone taxes If you do a 1031 exchange but this applies to investment porperty and business property but it does not apply to personal residences as too many people beleive.
Contrary to a popular belief in the real estate industry that you have to buy or reinvest your money to exclude the gain from your taxes, the 1034 code was repealed in 1997 and it was replaced by IRS code 121 (b)(3) where the homeowner can sell its primary residence every two years without having to pay taxes on the gain limits mentioned above.
The IRS code that people confuse with personal residences is the popular 1031 exchange where an investor may buy a “like kind” investment or business property and keep trading up in order to postpone taxes. Notice I said postpone and not eliminate. On 1031 exchanges, the investor eventually will have to pay taxes when he/she sells the last purchased property and stops trading up.
Unfortunately, when home prices are declining, as they are now in many areas, tax breaks for homeowners are hard to find, in fact, some tax codes may compound your troubles.
If, for example, you sell your home for less than you paid for it, you can't deduct your losses because losses are only deductible on business or rental properties. Worse, if your lender forgives or cancels part of your mortgage debt, the amount of debt that's been forgiven is considered taxable ordinary income in addition to capital gain if you have a recourse loan. If you have a NON-RECOURSE LOAN, you may have capital gain only.
That means some people who have lost their homes as a result of the sub-prime market collapse and adjustable rates now may face a financial burden.
Don't blame the IRS; it's simply enforcing the existing IRS codes. But with foreclosures and short sales on the rise, lawmakers are looking to provide relief. And it looks as if that relief could be coming soon. Hopefully they will learn from the mid nineties when we had a similar situation. It is reelection year so the chances of getting some relief are good.
Basically, this is the way it is now: Say you owe $500,000 on your house and can't afford your mortgage payments. Your home goes into foreclosure. The bank sells the house for $400,000 and forgives the remaining $100,000 debt. Even though you didn't receive a dime from the deal, the IRS will treat the entire $100,000 as ordinary income income. If the adjusted baisis of your proerty is less than fair market value oand the outstaniding loan balance, you may also have capital gain income from the sale of your home.
If you're in the 25% tax bracket, you'll owe the IRS $25,000 by April 15, 2008, unless the debt is discharged in bankruptcy or you prove the IRS that you were financially insolvent at the time the debt was forgiven. Most sellers that are forced to do short sales are.
Even homeowners who try to avoid foreclosure through a short sale, risk triggering a big tax bill, in a short sale, a home is sold for less than the amount owed on the mortgage; the lender agrees to forgive the balance. That keeps a foreclosure off your credit report, but you'll still be liable for taxes on the forgiven debt. Some states like California have some protection for the borrower where the borrower is not personally liable for loans that are secured by their primary residence. These loans are known as non-recourse loans. How do I know if my loan is a recourse loan or a non-recourse loan? Most residential loans in California are non-recourse. If you are not sure contact your lender representative or an attorney.
Good news. On non-recourse loans you don’t have to worry about ordinary taxable income from the cancellation of the debt or having to pay back the difference to the lender. You may have, however taxable capital gain from the sale of your home even if is a short sale. The IRS code interprets this as a loss to the lender and a gain to the borrower. The good part is that the sale is treated as a conventional sale and you are allowed to have $250,000.00 capital gain exempt form taxes on the sale of your main residence and $500,000.00 if you are married. IRS code 121(b)(3)
Contrary to popular belief, borrowers have other options: Say the same scenario as above applies except that the property happens to be your primary residence and you have lived in it for at least 2 years out of the past 5 years prior to the short sale transaction. In this case the $100.000.00 gain is excluded from your taxable income because the loan was a non-recourse loan and the property was your main residency as per IRS code 121 and IRS Publication 523. You don't have to buy another property like most people beleive in order to eliminate taxes. The IRS CODE 121(b)(3) replaced the old 1034 CODE in 1997.
Say you did not get to live the whole two years in the property and you had to sell it sooner due to interest adjustments that are now killing you. There is such thing as unforeseen circumstances acceptable to the IRS like; loss of employment, health reasons, multiple births from same pregnancy, job transfer, divorce and others to mention a few.
Legislation introduced Monday in the House Ways and Means Committee would exclude forgiven mortgage debt on a primary residence from any income tax. The bill is expected to include debt forgiven since the start of this year. By making the relief retroactive, the legislation would allow tens of thousands of taxpayers who have lost their homes this year to avoid a big tax bill.
All the bad news I read in the paper and other internet articles basically tell you that short sales are bad because they are taxable to the seller.
This is partially true. They have to take in consideration that the most important elements that determines the taxability of a short sale transaction gain are: If the loan is RECOURSE or non-recourse, Has the seller used his/her home as a primary residence for more then two years out of the last 5 years prior to the short sale? Is the seller financially insolvent or bankrupt? Does the seller have an unforeseen circumstance like loss of employment, job transfer, divorce, health hardship, multiple births from same pregnancy, and other “unforeseen circumstances that the IRS considers acceptable to exclude taxes from short sales gain. These unforeseen circumstances also apply to household members that are related to the seller.
In my personal experience most sellers fall in at least one of the above scenarios. At least in the Southern California are where my office is located. It is worth it to mention that some sellers will have short sales on rental properties that they purchased as investment or business. These are the exceptions but if you fall in this category you still have a silver lining because the loss generated from the sale may offset the gain from the cancelled debt.
Great News! With the recently approved Mortgage Foregiveness Debt Relief Act of 2007, you don't have to meet so many requirement to be eligible to eliminate the the taxes from foreclosures and repossessions. Basically, if you had debt cancelled from short sales, foreclosures, and repossesions from your residential mortgage. You don' have to pay ordinary income taxes on said cancellation of debt income, also clled ghost income becauese you never received said income.
This general information is provided by Ace Tax and Realty and it is not to be constructed as legal advice or counseling of any form. Ace Tax and Realty is a registered tax preparer and a California Real Estate Broker. All information contained here in is to be confirmed with a qualified professional
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