First of two parts: Tax relief available, but many factors dictate how much
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An unfortunate event in this economic crisis is the increase in short sales and foreclosures of homes.
In general, a short sale is a sale by an owner in which the amount owed on the property is greater than the amount the seller will realize from the sale. The seller must obtain an agreement from the lender that the proceeds from the sale will satisfy the debt in full in order to convey clear title to the property to the buyer.
A foreclosure or a deed in lieu of foreclosure results in the repossession of a property by the lender due to default on the loan on the part of the borrower.
Each of these events can carry significant tax consequences unless the borrower meets certain exclusions.
With either a short sale or a foreclosure, two distinct, potentially taxable events can occur. These include: (1) income resulting from the forgiveness of the debt is realized by the homeowner and (2) gain or loss resulting from the sale of the residence to a third party or deemed sale of the residence to the lender in satisfaction of the debt must also be considered.
The Mortgage Debt Foregiveness Act of 2007 and the Emergency Economic Stabilization Act of 2009 provide tax relief for debt forgiven through a short sale, foreclosure or deed in lieu of foreclosure on a principal residence.
Generally, to qualify as a taxpayer’s principal residence, the taxpayer must own and use the property as his or her primary residence for periods totaling two out of five years before the sale. Under Internal Revenue Code Section 108, the discharge of qualified debt incurred to buy, construct or substantially improve a principal residence can be excluded from income if the discharge occurs in calendar years 2007 through 2012. The residence must secure the debt. Up to $2 million of forgiven debt is eligible for this exclusion for married couples filing joint tax returns.
If the taxpayer does not meet the Principal Residence Debt Exclusion under the Mortgage Debt Forgiveness Act of 2007 or the Emergency Economic Stabilization Act of 2009 discussed above, they must look to other provisions for possible tax relief.
Recourse versus nonrecourse
The first step is to determine if the debt is “recourse” or “nonrecourse.” If the debt is recourse, the borrower is personally liable for the debt and the lender is able to pursue the borrower’s other assets in satisfaction of the debt.
If the debt is nonrecourse, the lender’s remedy is limited to the property and the borrower is not personally liable for any deficiency. In California, most loans incurred to purchase a home are nonrecourse. Mortgages from refinancing a previous mortgage or home equity line of credit are typically recourse.
Cancellation of indebtedness
The second step is to determine if a taxpayer has cancellation of indebtedness (COI) income. When a property subject to nonrecourse debt is foreclosed on or is sold subject to a short sale, the property is treated as being sold for the balance of the mortgage. Therefore, there is no COI income.