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Selling a Home for Less
Than the Mortgage Debt |
The bubble has burst in many residential real estate markets. You might have borrowed heavily to buy in at the top of the market. Or perhaps you took out a home equity loan while prices were increasing. In either case, you could wind up with mortgage debt in excess of the current value of your home. That's bad enough. But if you have to sell, you could face income taxes too.
"The recent disturbances in the sub-prime mortgage industry are modest ... in relation to the size of our economy. But ... if your family is one of those having trouble making the monthly payments, this problem doesn't seem modest at all. "
-- President George W. Bush |
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The White House
Plan to Help Homeowners
"A federal bailout of lenders would only encourage a recurrence" of the sub-prime mortgage problem, President Bush said. However, "there are many American homeowners who could get through this difficult time with a little flexibility from their lenders, or a little help from their government," he added.
One of the steps President Bush proposed taking on August 31 involves a change in the federal tax code to "make it easier for homeowners to refinance their mortgages during this time of market stress."
Under current law, homeowners who are unable to meet their mortgage payments can face an unexpected tax bill, as described in this article.
President Bush said that with a few changes to legislation discussed in the House and the Senate, the administration can support tax law provisions that provide relief. Generally, under the proposals, borrowers who win partial forgiveness of their debt would not have to pay tax on the amount forgiven. |
Real estate pros often call a sale where the mortgage debt exceeds the net sale price (after subtracting commissions and other costs) a "short sale." To illustrate the tax implications, here are a couple examples:
Example 1: Assume you paid $190,000 for a residence that you could sell for $250,000. However, the first and second mortgages against the property total $280,000. If you sell, you'll have a tax gain of $60,000. Reason: The sale price exceeds the property's tax basis ($250,000 sale price minus $190,000 basis).
Will the IRS cut you any slack since you're $30,000 in the red ($280,000 debt compared to $250,000 sale price). Unfortunately, no. You can have a tax gain without actually having any cash to show for it. Mortgage debt doesn't affect the calculation.
The good news is you'll probably be able to exclude the $60,000 gain, for federal income tax purposes, thanks to the home sale exclusion break. Assuming the requirements are met, an unmarried person can pay no tax on gain of up to $250,000 ($500,000 for married joint filers). If you qualify, the $60,000 gain won't trigger a federal income tax bill. (There may or may not be state income tax.)
Of course, it's also possible to have a short sale for less than what you paid for the property.
Example 2: Assume you paid $310,000 for a home that you can now sell for only $250,000. The first and second mortgages against the property total $280,000. You'll have a $60,000 loss if you sell ($250,000 sale price minus $310,000 basis). Will the IRS allow you to write off the loss? Sorry, but no. You can only claim a tax loss on investment property. A loss on a personal residence is generally considered nondeductible. In most states, the same principle applies.
What happens with the $30,000 still owed to the mortgage lender in both of the preceding examples ($280,000 debt versus $250,000 sale price)? Usually, the lender won't provide any relief. You'll have to pay the $30,000 and you won't get a tax break for it. However, if the lender decides to forgive some or all of the $30,000, the forgiven amount constitutes "cancellation of debt" (COD) income for federal tax purposes.
Tax Rules When Debt is Cancelled
The general rule is that COD income is taxable, although Congress is discussing a change in the tax code (see right-hand box). Currently, for the year the cancellation of debt occurs, the lender is supposed to report the income amount to you (and the IRS) on Form 1099-C. As stated earlier, you generally must report the COD amount as income on your tax return. However, there are exceptions to the general rule. Here are those most likely to apply under Internal Revenue Code Section 108:
Bankruptcy - If a borrower is in bankruptcy proceedings when COD occurs, it is entirely excluded from taxation.
Insolvency - If the borrower has debts in excess of assets, the COD income is excluded from taxation as long as the borrower is still insolvent after the debt cancellation occurs. On the other hand, if the COD causes a borrower to become solvent, part of the COD income is taxable (to the extent it causes solvency), and the rest is tax-free.
Deductible Interest - To the extent cancellation of debt income consists of unpaid mortgage interest added to your loan principal and then forgiven, the amount that you could have deducted if you had actually paid it is tax-free.
Seller-Financed Debt - If COD income is from forgiven seller-financed debt (in other words, mortgage debt owed to the propety's previous owner), it's tax-free. However, the tax-free amount is then subtracted from the home's basis. If you later sell the property for a gain, the gain will be that much bigger. As explained earlier, however, you can probably exclude the gain.
What About Foreclosure?
Up until now, we've only dealt with short sales when the home is sold to a third party. What happens if the lender forecloses?
Let's say a property is foreclosed or transferred to the lender in a deed in lieu of foreclosure transaction (which amounts to the same thing for tax purposes). When the mortgage debt exceeds the property's fair market value (FMV), the tax rules treat the foreclosure as a sale for the FMV figure.
So a tax gain is triggered when the home's FMV exceeds the property's basis. However, a borrower can probably exclude the gain under the home sale gain exclusion rules. If the property's tax basis is less than FMV, the foreclosure will generally trigger a nondeductible loss.
If the lender then forgives all or part of the difference between the higher debt amount and the home's lower FMV, the forgiven amount is COD income. It's taxable unless one of the exceptions explained earlier applies.
Example 3: Assume an owner borrowed heavily against the value of his home when local real estate prices were rising. Then the market dropped and the home was foreclosed. The home's FMV was $250,000 when the foreclosure took place. The property's tax basis was $210,000. There was a $180,000 first mortgage against the property and a $100,000 second (total debt of $280,000).
Now assume the $180,000 first mortgage and $70,000 of the second mortgage get paid off when the lender sells. The owner scrapes up $10,000 to pay off part of the $30,000 second mortgage balance. The lender forgives the last $20,000. Here are the federal tax results:
1. The foreclosure triggers a $40,000 gain ($250,000 FMV minus $210,000 tax basis). The gain can be excluded under the home sale gain exclusion break, assuming the taxpayer qualifies.
2. The $20,000 forgiven by the second mortgage lender is taxable COD income, unless one of the exceptions explained earlier applies.
Conclusion: A real estate short sale or foreclosure transaction can potentially result in taxable gain and COD income. Contact your tax adviser if you have questions about the tax consequences of real estate short sales.
(For more information, click here to read our previous article, "In the Wake of the Sub-Prime Crisis: A Brave New World")
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