Tax Ramifications of Short Sales and Foreclosures – Written by a San Diego CPA
In this very timely article, Steven Cushman CPA in Mission Valley, San Diego explains the tax ramifications of Short Sales and the tax consequences of Foreclosures. As Real Estate Professionals, we are constantly exposed to Distressed Homeowners who inquire whether a Short Sale or Foreclosure makes sense. While none of us are licensed to provide tax advice, I am pleased to share this useful summary written by Steven Cushman CPA in Mission Valley, San Diego which details the tax ramifications of Short Sales along with the tax consequences of Foreclosures. I hope you find this information useful.
Tax Ramifications of Short Sales and Foreclosures
By: Steven A Cushman, CPA
(Bonk & Cushman CPA’s located in Mission Valley, San Diego, CA)
An unfortunate result of the mortgage crisis our country is experiencing will be felt at tax time by those individuals who have lost their homes as a result of foreclosure or a short sale. Both situations reveal the severe cash flow problems homeowners are facing and to add insult to injury the tax authorities want their piece of the pie. When a lender forgives all or a portion of a debt, a 1099-C for Cancellation of Debt, is issued for the forgiven amount. According to the tax code this 1099-C represents income taxable at your ordinary tax rate. To determine the tax impact of a foreclosure or short sale several factors must be considered but a good place to start is with the character or nature of your mortgage.
Non-recourse or Recourse?
One of the primary considerations when discussing the impact of a short sale or foreclosure is whether your loan is non-recourse or recourse. The difference is significant in several ways.
Non-recourse: That means the lender can only take back the residence and nothing else. Most loans in California for the acquisition of a primary residence are non-recourse. If you still have the original non-recourse loan and your home is foreclosed on you should not receive a 1099-C and no further action is allowed by the lender to collect. Their security was limited to the home and whatever they receive for it in a short sale or foreclosure sale is the full extent of the amount they are entitled to receive.
Recourse: A recourse loan is one where the debtor is personally responsible for the debt. It may be secured by the residence but that is not the only security the lender has. The other assets of the debtor can be pursued to make up any amount not covered by the property. This means that the debtor can be sued, potentially have wages garnished, be forced to liquidate investment portfolios and in general be on the hook for the difference between the amount owed and the amount received by the lender. The non-recourse aspect of an original loan on a residence is often changed by a refinance. Most refinanced properties have recourse loans.
Tax Ramifications
In recognition of the severity and scope of this problem our legislators have passed laws that allow the forgiven debt, indicated by the 1099-C, to be excluded from federal tax, if, certain rules are followed and accommodations made. These rules and accommodations have made the tax return preparation much more complicated. Again the effect will rely heavily on the recourse/non-recourse aspects of the mortgage on the property, but not solely on that aspect.
Non-recourse: The property is treated, for tax purposes, as though it was sold for the balance of the mortgage, if this results in a gain it may be eligible for exclusion (up to $500,000 for taxpayers who file Married Filing Jointly). A calculation must be done to determine whether there is a gain. Additionally, the taxpayer needs to determine if they meet the requirements to have some or all of the gain excluded.
Recourse: The property is treated, for tax purposes, as though it was sold for fair market value (often this amount is what the lender received at auction). If the lender forgives the balance of the loan there is cancellation of debt income, which is taxed at ordinary income tax rates. This is the most common occurrence and results in a complicated tax situation. There is a sale of the property with the possibility of excludable gain as above plus cancellation of debt income. The cancellation of debt income may be eligible for tax relief from the federal government if certain conditions are met. The Mortgage Forgiveness Debt Relief Act of 2007 allows for the exclusion of the cancellation of debt income if it is “qualified principal residence indebtedness”. This act has been extended through 2012. The “qualified” aspect of this is what can cause problems for some, only acquisition indebtedness qualifies for this exclusion. If a taxpayer has done a cash-out refinance and used the proceeds for anything other than home improvements that amount would not be qualified debt and would be subject to tax. Additionally, if you use the exclusion you are required to reduce the basis of the home by the amount forgiven, Form 982 is used for this. This reduction could then result in a gain on the sale of the property. For most this gain can be offset if they qualify for the sale of home exclusion authorized by the Taxpayer Relief Act of 1997 mentioned above.
The end result is a tax preparation headache even for those familiar with the rules and the necessary forms needed to comply with these regulations. My advice for anyone facing this situation is to consult with an experienced professional for at least this one year’s tax return preparation. If you submit a tax return that is incorrect it could cost thousands of dollars in tax and/or fees to get it corrected.
For more information about tax ramifications of Short Sales, please contact Steven Cushman, CPA in Mission Valley, CA.
For more information about tax ramifications of foreclosures, please contact Steven Cushman, CPA in Mission Valley, CA at (619) 297-8080. Conveniently located at the intersection of I-163 and I-8 in Mission Valley, San Diego, CA.
Steven Cushman, CPA in Mission Valley, CA is a partner with Bonk & Cushman CPA’s, who specialize in providing quality, personalized financial guidance to local individuals and businesses. Bonk & Cushman CPA’s’s expertise ranges from basic tax management and accounting services to more in-depth services such as audits, financial statements, and financial planning.
Additional online tools are provided by Steven Cushman, CPA in Mission Valley, CA including financial tools.
To learn more about tax related terms, click here for a glossary of terms provided by Steven Cushman, CPA in Mission Valley, CA
Steven A. Cushman, CPA
Bonk & Cushman, CPAs
591 Camino De La Reina, #1216
San Diego, CA 92108
Phone: 619 297-8080
Fax: 619 297-8087
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