Short Sellers Beware: Unless Congress Passes Extension, Underwater Sellers Could See Income Tax Consequences

by Charles J. Fisher, Esq.

(LONG ISLAND, NY) The Hendersons owe $456,000 on the mortgage for their principal residence on Long Island. They managed to find a buyer for their home willing to pay $320,000, which is close to the home’s fair market value but well below the $456,000 owed on their mortgage. A home which is worth less than the secured lien against the home is referred to as “underwater” or “upside down”. The Hendersons have negotiated with their lender and the lender has approved the sale of the home at $320,000, which means that the Hendersons will be forgiven part of their mortgage debt, to the tune of $136,000.

Up until December 31, 2013, there was a law which was applicable to the above situation, called the Mortgage Debt Relief Act. The Mortgage Debt Relief Act generally allowed taxpayers to exclude from taxable income the forgiveness of mortgage debt on a principal residence, as long as the forgiven debt was used to (1) buy, build or substantially improve a principal residence, or (2) refinance a debt incurred for those purposes. A taxpayer could exclude up to $1 million of forgiven debt or $2 million, if married and filing a joint tax return.

In our scenario, if the Hendersons had completed their short sale in 2013, they would not have had any tax liability on the $136,000 forgiveness of mortgage debt. However, if Congress does not pass an extension of the Mortgage Debt Relief Act, the Hendersons will be issued a 1099-C from the forgiving lender and may have to pay income tax on the $136,000 in forgiven mortgage debt. In essence, then, the Hendersons may be jumping out of the $456,000 mortgage frying pan and into the tax liability fire of $136,000 in added taxable income.

Assuming that the extension of the Mortgage Debt Relief Act dies in Congress due to ongoing partisan fighting, there are two other ways for the Hendersons to avoid having to pay income taxes on the $136,000 of forgiven debt.

The Bankruptcy Option:
If the Hendersons qualify, they can file for bankruptcy and obtain a discharge of their personal liability for the mortgage debt, among other debts like credit card debt. It is crucial to note that the Hendersons must file bankruptcy PRIOR TO the short sale. Prior to the short sale, the debt obligation is to the lender and can most likely be “discharged” (the bankruptcy term for “cancelled by order of the court”). When debt is discharged through bankruptcy, it is not a taxable event for the debtor. After the short sale occurs, however, the debt to the lender is transformed into a potential debt to the Internal Revenue Service, and becomes a debt not able to be discharged in bankruptcy (a priority debt).

The Insolvency Option:
The other way for the Hendersons to avoid the tax liability on the forgiven debt is to claim to the IRS that they were insolvent at the time of the short sale. The definition of insolvency in this case is that the total of one’s debts exceeds the total of one’s assets (exempt assets such as retirement accounts are included in this calculation). This requires filing an extra form with one’s tax returns. Proving insolvency is somewhat more difficult than holding a bankruptcy discharge order in your hand, but it is nevertheless another way to avoid the tax liability.

Other Forgiven Debt (Second Homes, Investment Properties, Credit Card Debt):
This article should raise at least a bit of concern for people who are thinking about settling their credit card debt or short selling a property other than their principal residence. Let’s suppose that the Hendersons, instead of short selling their principal residence, were trying to settle their credit card debt. They have $50,000 in debt, spread among four credit cards. They manage to settle with each credit card company for a total, among the four cards, of $20,000. They can expect to receive a 1099-C from each of the credit card companies, for a total of $30,000 in cancellation of debt income. Again, there are two ways to avoid a tax liability on this forgiveness of debt: (1) filing of bankruptcy instead of settling the debts, and (2) settling with each company, then claiming insolvency on the next tax return.

This author strongly suggests speaking with an attorney and accountant before making a decision to short sell secured property like a house or settling your credit card debt.

This article was sent into NewsLI.com by Charles J. Fisher, Esq. of The Fisher Law Firm P.C. in Commack. Mr Fisher has been practicing real estate and bankruptcy law on Long Island for nearly 20 years. The article was edited and published today, August 15th, 2014 at 4:21 PM.