Tax Consequences of Short Sales

One of the unfortunate facts about the current San Diego real estate market is that more than half of the homes for sale in most areas are short-sales. In a short sale situation, the home owner is seeking to sell the house, and the sale will net less to the home owner than the owner owes the bank(s) for the home mortgage. The owner will be “short” when they go to repay the home mortgage with the proceeds of the sale; hence the name short-sale.

Short sales can be a less onerous alternative than foreclosure to home owners in financial distress. Foreclosures stay on a person’s credit report forever. Short sales are also a major ding on a credit report, but the history of a short sale is eventually removed from the credit report. Still, there are potential drawbacks or dangers to property sellers who go through with a short sale. Adverse tax consequences are the first of these dangers that we’ll discuss.

Let’s say Mr. Brown purchased a home for $400,000 with 100% financing. When property values increased, Mr. Brown took out a $100,000 home equity loan and spent the money on a new car and college expenses for a child. Now Mr. Brown has lost his job and he is selling the house in a short sale. He will net $400,000 from the sale (after selling expenses) so Mr. Brown is short $100,000. The bank agrees to forgive the $100,000.

The $100,000 forgiveness of debt is actually a $100,000 gain for tax purposes. It is known as debt-discharge income, or DDI. The lender will actually issue an IRS Form 1099-C to report this distribution of taxable income to Mr. Brown.

Fortunately for Mr. Brown, this income will probably not be taxable for federal income tax purposes. The federal “home-sale-gain exclusion” exempts short sellers from needing to report DDI gains on their Form 1040. However, this same exclusion may not apply on the state income tax level.

For state tax purposes, however, DDI can be considered taxable income. There are specific DDI exclusions on the state level, but not all short sellers will qualify. Here are the general rules:

1) Up to $2 Million of DDI may be excluded from income if the mortgage debt was used to acquire, build, or improve the borrower’s principal residence. So if the home equity loan was used for those purposes Mr. Brown will probably be safe from state tax liability on the DDI. But if Mr. Brown used the home equity loan money to buy a new car, go on vacation, or send a child to college, the DDI may still be taxable.
2) DDI is tax-free if the seller/borrower is in bankruptcy proceedings when the DDI occurs.
3) If the seller/borrower is insolvent (i.e. has more debts than assets) then the DDI is tax-free unless the DDI itself brings the seller/borrower back to solvency, in which case the amount of the difference could be subject to state income tax.
4) Any amount of the DDI that is unpaid mortgage interest (from missed payments) is tax-free.
5) Seller-financed mortgage debt owed to a prior owner of the home is tax-free DDI, but the amount of any tax-free DDI must be deducted from the property basis.

Short sellers of San Diego homes and owners of any real property in the U.S. are strongly advised to consult with their legal and tax professionals to determine the tax consequences and other possible consequences of a short sale. The above discussion is not legal advice. These are just informal tips offered by your San Diego real estate professionals.