The fact that many people are simply choosing to walk away from their underwater mortgages or being forced into a foreclosure or short sale by economic necessity is currently the norm especially here in Las Vegas. One of the main concerns people have as they consider if a short sale is right for them is their possible tax liabilities for this debt. Fortunately, there is good news for many homeowners who qualify out there because there are some laws that may help them during this most difficult time.

The Mortgage Debt Relief Act of 2007 (H.R. 3648) generally allows taxpayers to exclude income from the discharge of debt on their principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure or short sale, qualifies for the relief.

But you must decide soon. This provision applies to debt forgiven in calendar years 2007 through 2012. Up to $2 million of forgiven debt is eligible for this exclusion ($1 million if married filing separately). The exclusion does not apply if the discharge is due to services performed for the lender or any other reason not directly related to a decline in the home’s value or the taxpayer’s financial condition.

No tax liability for some loans secured by your primary home
In the past, homeowners using short sales or deeds in lieu of foreclosure were required to pay tax on the amount of their forgiven debt.  The law provides tax relief if your deficiency stems from the sale of your primary residence, or the home that you actually live in. Ski condos, for example, do not qualify.

Here is an overview of the rules:

  • Loans on other real estate. If you default on a mortgage that’s secured by property that isn’t your primary residence (for example, a loan on your vacation home), then you’ll owe tax on any deficiency.
  • Loans secured by but not used to improve primary residence. If you take out a loan, secured by your primary residence, but use it to take a vacation or send your child to college, you will owe tax on any deficiency.
  • The insolvency exception to tax liability. If you don’t qualify for an exception under the Mortgage Forgiveness Debt Relief Act, you might still qualify for tax relief. If you can prove you were “legally insolvent” at the time of the short sale, you won’t be liable for paying tax on the deficiency.
  • Legal insolvency occurs when your total debts are greater than the value of your total assets (your assets are the equity in your real estate and personal property). To use the insolvency exclusion, you’ll have to prove to the satisfaction of the IRS that your debts exceeded the value of your assets.
  • Bankruptcy to avoid tax liability. In Colorado, you may also be able to get rid of this kind of tax liability by filing for Chapter 7 or Chapter 13 bankruptcy, if you file before escrow closes. Of course, if you are going to file for bankruptcy anyway, there isn’t much point in doing the short sale or deed in lieu of foreclosure, because any benefit to your credit rating created by the short sale will be offset by the bankruptcy.

Next week, we’ll discuss some common issues of the law. If you have specific questions related to your own scenario, please contact us and we would be happy to provide you with a free, no obligation consultation to determine if a short sale is right for you.