When talking to sellers who are considering a short sale on their San Diego property, I frequently get asked about the tax implications of doing a short sale.  Because the lender agrees to settle the debt on the property for less than the amount they are actually owed, the Internal Revenue Service allows the lender to write off this loss.

Short Sales & Federal Tax Implications

The IRS considers “debt relief” to be income for tax purposes. For example, if your lender writes off $100,000 on the short sale of your San Diego property, they will mail you a 1099-C for that amount.  You would be required by the IRS to report this 1099-C when you file your income taxes. The “C” refers to “Cancellation of Debt” and IRS tax law states that cancelled debt is is considered taxable income.

I am already experiencing a hardship and now the IRS is going to stick it to me?  Not Necessarily!

The Majority of people who qualify for a short sale are not taxed because there are a few key exceptions that exclude them from having to pay taxes on their short sale.

The Mortgage Tax Debt Relief Act that former President Bush signed into law in January 2008, states that homeowners who complete a short sale on their primary residence, and have a purchase money loan (meaning they have not done a cash out refinance on their home) will not have to pay taxes on the loss that their lender incurs in a short sale.

What if I have completed a “cash out refinance” on my home?  Homeowners who have pulled cash out of their home but have reinvested that money back into their home to “substantially improve” it, are also excluded from paying income taxes on their short sale.

What if I completed a “cash out refinance” and have not reinvested the “cash out” back into my home?  If you pulled cash out of your primary residence but spent it something other than improving your home or if you are attempting a short sale on a vacation home or investment property, these situations will result in a taxable event as defined by the IRS unless you qualify for the last remaining loophole known as the “Insolvency” exclusion.

How Do I know if I qualify for the “Insolvency” exclusion?  IRS tax law states that you are “insolvent” if your debts, including the subject mortgage, exceed the value of all of your assets.  To rephrase this, if you have more debt than you do money or assets, you are deemed insolvent. In this case, the IRS does not require you to pay taxes on the loss the lien holder took in the short sale so you dodge the tax bullet.

 Given that a short sale approval requires some form of an economic hardship, the majority of the people who qualify for a short sale are in this unique situation and are therefore excluded from paying taxes on their short sale “gain”.

Short Sales & State Tax Implications

California now has its own version of the Federal Mortgage Tax Debt Relief Act which is known as Senate Bill 1055  It conforms to the federal law, but applies to California state income taxes for the purposes of a short sale.

There are, however, some major differences between the state and federal law. Most importantly, the California law was only valid until the end of 2008. Unfortunately, this law is no longer in effect.

On a positive note, debt forgiveness on non-recourse loans is not taxable in California. In other words, if you still have the same loan you bought your home with, you will not be subject to CA state income taxes.

Legislation is currently pending in CA legislature at this time regarding how to handle the taxation of debt forgiveness on recourse loans (meaning loans where a “cash out” refinance has occurred).

We highly recommend you review your specific tax scenario with your CPA or accountant and have them answer any tax questions that you have. We are not tax advisers and are not licensed to give tax advice.  We are however, willing to have a conference with you and your CPA to define a strategy that will work in your best interest.

We are not licensed accountants and given the unique complexities of each individuals tax situation, we highly recommend you check with your CPA or accountant.   IRS Form 982 is the IRS form for debt relief regarding short sales. We gathered our definition of “Insolvency” from  this form.

The Mortgage Tax Debt Relief Act was originally passed to go until the end of 2008, but it has recently been extended to the end of 2012.

For more questions about Short Sales, give us a call at 619-309-8011 or email us at Chad@DanneckerAndAssociates.com