Tax Treatment on Foreclosures and Short Sales

Q. I am in the process of selling my house in a short sale. My mortgage is $450,000. The current value of my house is $375,000, and my lender has agreed to allow me to sell it for that price. Under the terms of the sale, my broker will get a 3 percent commission and after all closing costs are paid, the lender will get all of the net sales proceeds -- $360,000. I have been told that I will have to pay some kind of income tax. Please advise.

A. If this is your principal residence and if the money you borrowed was used to buy, build or substantially improve that home, you will not have to pay income tax on debt that was forgiven by your lender.

This is a departure from the general rule, which requires debtors to report all forgiven debt as ordinary income. Before the so-called mortgage meltdown, there were two exceptions to this rule that affected homeowners. If your debt was discharged by a bankruptcy court or if you were insolvent, you were not obligated to pay any tax on this canceled debt.

However, Congress amended the law. For debts forgiven in 2007 through 2012, up to $2 million of forgiven debt can be excluded from the obligation to pay income tax ($1 million if married filing separately). And, according to Julian Block, a prominent tax lawyer, even if you are a single taxpayer, you still can exclude the full $2 million. Furthermore, you can add up all of your qualified losses during these six years, so long as the total does not exceed the cap.

This is an interesting loophole. You can claim the exclusion only for your principal house, but you might be able to take advantage of a strategy to cover more than one home. If your first residence is foreclosed on (or sold via short sale), nothing prohibits you from moving into your second home and establishing it as your new principal residence. As long as your total losses do not exceed the $2 million cap, you can also sell that house at a short sale (or let it go to foreclosure) and not be required to pay tax on forgiven debt.

However, the new law does not apply to all forgiven or canceled debt. If it is a mortgage on your vacation home, your car loan or your credit card debt that is canceled, that forgiven debt will not qualify for the exclusion, unless you are insolvent or file for bankruptcy.

Let's use this example:

Becky bought her home in 2002 for $315,000 and obtained a $300,000 mortgage. A year later, she got a second mortgage for $50,000, which was used to add a garage to her house. In 2008, when the outstanding balance of those two loans was down to $325,000, Becky obtained a new loan of $400,000. For tax purposes, her qualified principal-residence indebtedness was $325,000. She used the additional $75,000 ($400,000 -- $325,000) to pay off personal credit cards and to pay her daughter's college tuition.

She sold her house for $300,000 through a short sale. The new lender forgave $100,000. However, under the new law, she can exclude only $25,000 ($100,000 canceled debt minus the $75,000 that was not qualified indebtedness). To add insult to injury, unless Becky files for bankruptcy relief or can claim insolvency, she will have to pay ordinary income tax on the $75,000 that cannot be excluded.

Had Becky used the refinance proceeds to substantially improve her home, she would have been able to exclude more of the canceled debt.

How is this handled when filing your next income tax return? First, if your debt is reduced or eliminated, your lender must send you Form 1099C, "Cancellation of Debt." By law, this form must show the amount of debt forgiven and the fair market value of any property given up through foreclosure or a short sale. If you are in this situation, make sure that the information provided on the form is accurate; keep in mind that the Internal Revenue Service will get a copy of this form.

If you qualify for the exclusion, you must complete Form 982, "Reduction of Tax Attributes Due to Discharge of Indebtedness," and attach it to your federal income tax return. If you do not qualify, the canceled debt shown on the lender's form is treated as ordinary income, for which you will have to pay the appropriate tax.

For more information, the IRS has issued Publication 4681, "Canceled Debts, Foreclosures, Repossessions and Abandonments," which you can obtain at http://www.irs.gov/publications.

Additionally, Julian Block has written "The Home Seller's Guide to Tax Savings," which can be purchased at http://www.julianblocktaxexpert.com.

Benny L. Kass is a Washington lawyer. For a free copy of the booklet "A Guide to Settlement on Your New Home," send a self-addressed stamped envelope to Benny L. Kass, 1050 17th St. NW, Suite 1100, Washington, D.C. 20036. Readers may also send questions to him at that address or contact him through his Web site, http://www.kmklawyers.com.