To learn more about tax liability in short sales, see Nolo's article Short Sales and Deeds in Lieu of Foreclosure.
Jan 11, 2008
Until this year, people who defaulted on their mortgage would often get an extra kick in the teeth--a tax bill on the difference between what they owed and what the property was finally sold for. With a new federal law, Congress has changed this for the better. How the old law worked. Prior to 2007, if you owed $300,000 and your home was sold at auction for $250,000, the lender would file an IRS tax form 1099 reporting the $50,000 difference as plain old taxable income to you. Since debt forgiveness just doesn't seem like it should be taxed as income, this practice left many people fuming (or worse). Mercifully, the Internal Revenue Code allowed you to escape the tax if you could prove you were insolvent at the time or if you got rid of the debt in bankruptcy. The new law. Now, with a few exceptions, Congress has done away with this practice (in a new law, H.R. 3648), effective for the 2007 tax year and the following two years. This means that whatever happens to your home mortgage during that period will not increase your income tax. Whether the law is allowed to sunset after 2009, or whether Congress acts to make it permanent, will probably depend on just how broke the government feels at the time. What this means: more options for those losing their homes. In past blog posts, I have touted bankruptcy as a good way around the tax issue--since debt discharged in bankruptcy has never been considered to be taxable income. I explained that if you were going to lose your home anyway, bankruptcy was preferable to foreclosure or some of the other remedies such as "short sales"and "deeds in lieu of foreclosure," all of which generated taxable income. Now, if your default is on a mortgage or other debt secured by your home that is used to buy or improve your home, you can choose the best possible course of action without worrying about the tax ramifications. In some cases this will be a short sale, in others a deed in lieu of foreclosure, or if your overall debt situation warrants it, a Chapter 7 or Chapter 13 bankruptcy. Exceptions to the new law. This tax break doesn't apply to loans for real estate other than your principal residence. If you walk away from a loan on your second home in the country, for example, expect a 1099 in the mail. Similarly, if you take out a home equity loan and take that world trip you've been dreaming of for 50 years rather than use the money to improve your home, you may end up on the wrong side of a tax bill. In both of these situations, bankruptcy will still be an attractive way to avoid income tax liability.