Monday, October 11, 2010

Short Sale vs. Foreclosure - Taxation Issues

In the wake of the real estate market meltdown, homeowners are often left singed with unexpected tax consequences from a foreclosure or short sale. Here are a few issues you may want to address if you, like many others, are left with a home that is “upside down” and are trying to determine your best course of action.

Tax treatment of foreclosures and deeds in lieu of foreclosure.

Foreclosure is the legal process whereby a lender obtains a court-ordered termination of a delinquent borrower’s interest in the borrower’s mortgaged property by forcing the sale of that property. The property is sold under the court’s supervision, with the proceeds going first to satisfy the mortgage, then other lien holders, then the borrower. In the current economic climate, of course, the fair market value of the property is likely to be lower than the amount borrowed to purchase that property. In that case, the proceeds are still applied first to the mortgage; however, an amount remains due on the loan. Depending on the type of promissory note signed by the borrower, the lender may have an action against the debtor personally for the balance.

If the debt is only secured by the real property, the debtor is not personally liable for the deficiency between the principal amount of the mortgage and the fair market value or sales price of the property, and the debt is referred to as a “non-recourse” debt. If the debt is "recourse," the debtor is personally liable for the debt above and beyond the value of the real property securing the debt. In Nevada, most mortgages in the residential context are recourse, and debtors are personally liable for any unpaid loan amounts on their mortgages after a foreclosure sale.

The tax treatment of a foreclosure also differs based on whether the debt is non-recourse or recourse. When a foreclosure (or deed in lieu of foreclosure) takes place in the recourse loan context, the debt is satisfied up to the fair market value of the property, and the transaction is treated as a sale. If the lender forgives the balance of the mortgage, the IRS treats the amount forgiven as ordinary income, which is reported to the borrower on “Form 1099-C Cancellation of Debt,” which must be reported as income on the borrower’s income tax return in the year of forgiveness. Hence the borrower is left homeless and may be taxed for the forgiveness of the debt above the fair market value of the house. There are certain exceptions that may apply, and you should consult with your tax advisor with the specifics of your situation.

When a nonrecourse mortgage is foreclosed, the property is treated as being sold for the balance of the mortgage regardless of whether the sale price equals or exceeds the amount borrowed. The balance of the loan above the fair market value of the home is not treated as income to the borrower; thus, the borrower is not taxed on any type of “forgiveness of debt income.”

Taxation of short sales.

A “short sale” is similar to a foreclosure in that the sale proceeds fall short of the balance owed on the property’s loan. It differs from a foreclosure because, in a short sale, both the lender and the borrower agree to sell the property at a loss in order to avoid foreclosure.

In a recourse debt scenario, even if the bank agrees to a short sale of your residence, the debt is not necessarily cancelled. Therefore, any debt not satisfied with the sale proceeds would be taxable as cancellation of debt income similar to the foreclosure situation above, with a few exceptions. For non-recourse debt, the seller and buyer can require the lender to cancel the debt as a condition of the short sale. In that case, the debt cancellation is included in the sale proceeds; therefore, it is not taxable as income to the seller.

A short sale can be a viable alternative to a foreclosure for debtors with nonrecourse debt and who qualify for certain exclusions. Be aware, however, that the lender has up to 6 years in the short sale context to try to recover a deficiency from the borrower compared to only 6 months in a foreclosure.

 - Attorney Robert Morris

No comments:

Post a Comment