Thinking of a Short Sale?

There was an article in today’s Tampa Bay Times that really ticked me off. For Debtors, Sell Now or Pay Later, described the probable tax consequences of a short sale of a primary residence  after December 31, 2012 when The Mortgage Debt Relief Act of 2007 will expire. The problem with the article was it could easily mislead the exact people that it was written to help. Specifically, not all primary residence forgiven debt can be excluded under The Mortgage Debt Relief Act of 2007 and failing to know how your case will be treated can easily cost you tens of thousands of dollars.

We live in an area particularly hard hit by the collapsing real estate bubble. Many, many homes are underwater (their owners owe more than the home is worth). Many homes have been foreclosed (the bank has repossessed the home) and many more have been sold as a short sale (sold for less than the mortgage balance).

Getting out of one of these underwater houses is not easy nor is it uncomplicated. If you are considering your options, you need a great realtor, a very knowledgeable CPA and maybe an experienced attorney. Missteps can cost you a fortune and keep you trapped for years.

HURDLE 1 Need to sell but mortgage greatly exceeds value

Many homeowners just can’t make their payments due to circumstances beyond their control. Frequently this circumstance is a job loss, a serious medical issue, a divorce or a death.

Some homeowners can make their payments right now but they need to reduce their expense very soon because of a pay cut or an upcoming retirement.

Others can make their payments but they need to move.

All of them need out from under the mortgage but don’t have the money to come up with the difference between what is owed and what the home will sell for in the current market. So, a short sale seems in order.

HURDLE 2 Avoiding the Deficiency Judgment

Many, but not all banks will negotiate the deficiency judgment in a short sale. Sometimes a really good realtor or attorney can get them to waive the right to pursue the deficiency all together. This is in contrast to a foreclosure where there will be a deficiency judgment.

In Florida, lenders have up to five years to file a deficiency action, so just because  you’ve already completed your foreclosure and haven’t seen one yet; doesn’t mean you won’t. Once a court grants the deficiency judgment, creditors have up to 20 years to collect the debt.

HURDLE 3 Tax on the Forgiven debt

So you find yourself a really experienced, aggressive short sale realtor, you resolve your family to leaving the home you love, you find a qualified buyer and you jump through the banks 1 million hoops to close on your short sale without a deficiency judgment. Yea, you! This probably took you a year of blood, sweat and tears but now you are free and ready to start over, right?

Not so fast – let’s make sure The Mortgage Debt Relief Act of 2007 is going to work for you.

When debt is forgiven (like when you got the bank to waive the deficiency judgment) the amount that is forgiven is generally taxed as ordinary income. I know it doesn’t make sense so here is an example:

Bill has a house that was once worth $200,000, Bill owed $170,000. Bill’s company left the state of Florida and to stay employed, Bill had to move to SC. He sold the house as a short sale for $90,000. The bank waived the $80K shortage.  Now the question is, does Bill have any tax consequence from that short sale?

If the property was not his primary residence (there a lots of IRS rules that define this, see Pub 4681), he is going to owe tax on the shortage just as if he had earned an additional $80K. If he is at a 25% tax rate he is going to owe $20K. It’s not the end of the world if Bill planned for this, but it makes for a very unpleasant surprise.

If the property was his primary residence, he may able to exclude that cancelled debt from his income.

First, he must pass the qualified principal residence test.  Generally, a qualified principal residence is the home you live in most of the time and you must have lived there 2 out of the past 5 years.

Next, he must ensure that the proceeds of the mortgage were used to buy, build or sustainably improve his main house.

This is one point the Times article left off and the issue that trigger an unexpected tax expense for many.

Sure, the people that bought at the top of market may be underwater due to a mortgage that was used to buy, build or improve their home, but many others refinanced at the top of the market and used that money to pay for education or medical expenses or to purchase other properties. These people may very well find they owe huge taxes on the canceled debt.

Even if you did use the mortgage money for other than the purchase or remodel of your primary residence, there is still hope. There is an insolvency test (although unlike other insolvency tests it includes most retirement accounts) that will get you out of owing the tax if in fact you are broke (again IRS has a complicated definition of “Broke“; so carefully read the publications AND contact a competent CPA).

The most important point here is that the whole short sale process  it’s very complicated and you need a good realtor and a good CPA to help you through it.

Don’t start the short sale process until you carefully plan how you will get over all three hurdles.