By Kira Bravo
Tax Manager, Moss Adams LLP
With housing prices still depressed, many people are considering doing something they never thought they would: Sell their home for less than what they still owe on their mortgage. This is what’s known as a short sale, and while it can get you out from under an unwanted mortgage, it can also have tax ramifications.
Here’s why: When debt is forgiven—as it is in a short sale, since the lender is accepting less than the total amount due on the loan—it results in income. This is referred to as cancellation of debt (COD) income, which is typically reported on your federal tax return and subject to tax at ordinary income rates.
Essentially, when you first borrowed the money, you weren’t required to include the loan proceeds you received as income because you were obligated to later repay the lender. When that obligation is forgiven, the amount is normally reported as income.
However, there’s a window of opportunity right now that can help you avoid tax on COD income.
Under the Mortgage Forgiveness Debt Relief Act of 2007, taxpayers can exclude from their gross income up to $2 million from the discharge of qualified personal residence indebtedness prior to Jan. 1, 2013. To qualify, the debt must have been used to acquire, construct or substantially improve your principal residence and be secured by the home. Also, you must have owned and used the home as your principal residence for at least two of the five years before the sale.
Let’s walk through a simple example.
Bob has owned his home for the past 10 years. In 2011 he decided he could no longer afford to continue paying his mortgage, so he moved out of the home and into an apartment. He began to rent his home with hopes that housing prices would rebound and he wouldn’t be forced to take a loss on the house. In 2012 he decides to go through with a short sale. He owes the bank $250,000 on the home, but it will sell for only $175,000. Bob’s debt forgiveness is therefore $75,000. The loan was used to acquire the home and is secured by the home.
In this example, Bob meets the criteria to exclude the debt forgiveness from his income because he lived in his home and used it as his personal residence for two of the prior five years, the debt was used to acquire the home, the debt is secured by the home, and he completed the short sale prior to Jan. 1, 2013. The lender will then provide both Bob and the IRS with Form 1099-C, showing the COD. Bob must report the debt forgiven on Form 982 and attach it to his tax return for 2012.
For a comparison, let’s say Bob completed his short sale in 2013.
In this case the debt forgiveness would be included in Bob’s income because it occurred after the end of 2012. With the top ordinary tax rate set to go up to 39.6 percent, this could mean a difference in tax of up to $29,700!
If you’re considering a short sale, know that the process can take a long time to complete—sometimes more than six months. Since this tax benefit is available only through the end of 2012, you should consult an advisor sooner rather than later to see whether a short sale is the right decision for you.
Kira Bravo has practiced public accounting since 2006. She provides tax planning, compliance and consulting services to closely-held businesses and their owners. She can be reached at 360-685-2223 or at firstname.lastname@example.org.