Tax Consequences of a Short Sale; the Bankruptcy ‘Cure’

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IRS tax debts after forgivenessUnlike Most Forgiven Debts, Debts discharged in Bankruptcy are not taxable events

While the housing market was in turmoil, many were looking to a short sale as a way out from under a house that was rapidly declining in value. A true short sale or deed in lieu of foreclosure involves a forgiveness of debt. The borrower either sells or simply hands the property back to the lender, and in exchange, the lender agrees to cancel the remaining amount due under the note. Debt settlement is another scenario where lenders may agree to forgive portions of a consumer’s debt.

Forgiven Debts Are Taxed As Extra Income

Generally speaking, when debt is cancelled or forgiven the lender issues a tax form, known as a 1099 C, reporting the amount of the forgiven debt to the IRS and the borrower. When a debt is forgiven in this way, it is reportable as income because you no longer have an obligation to repay the lender. Your income tax obligation goes up by the amount your lender forgave.

For example, you borrow $100,000 and default after repaying only $20,000. If the lender is unable to collect the remaining debt from you or decides to stop trying, there is a cancellation of debt of $80,000, which is added to the amount of income you pay taxes on. If you had been paying taxes based on a salary of $50,000, get ready to pay taxes as if you have earned $130,000 in that year!

The Mortgage Forgiveness Debt Relief Act Expires In 2013

The Mortgage Forgiveness Debt Relief Act of 2007 (expires in 2013) generally allows taxpayers the right to exclude debt forgiven as a result of a foreclosure on their primary residence. While the law is in place, you won’t have to pay tax on debt forgiven on your primary residence as long as all applicable conditions are met.

As a result, in today’s declining housing market, the 1099 C issue arises most frequently in the context of investment properties. Borrowers holding a portfolio of underwater investment properties will see their tax bill skyrocket in the event they successfully negotiate a short sale, deed in lieu of foreclosure or forgiveness of deficiency judgment after foreclosure. Any cancelled debt will result in the dreaded 1099 C and a tax bracket that will likely have no bearing on the borrower’s actual income.

The Tax Advantages of Bankruptcy Can Be An Attractive Option

There are exceptions to the forgiveness of debt rule. Bankruptcy can be an attractive option for over-extended real Estate investors because debts discharged in bankruptcy are not taxable events . When a consumer elects to file a bankruptcy case they have the option of shedding their secured debts (such as mortgages and car loans) by surrendering the collateral that served as security for the loan (car or home) back to the lender.

Under normal circumstances, surrendering a car or home back to a lender would result in the lender selling the property and holding you liable for the difference between the sale price and what you owed on the loan. If the difference is forgiven, the IRS will send a much bigger tax bill. However, when property is given back to a lender in the bankruptcy context, no remaining debt will be owed and no tax liability for the amounts discharged will result. The tax advantages of bankruptcy extend to almost any type of forgiven debt. Those lucky enough to negotiate a debt settlement with their credit card company will receive a higher tax bill whereas credit card debt discharged in bankruptcy is not taxable.