Tax Consequences of a "Short Sale" of Real Estate vs. Foreclosure
July 1, 2008
© 2008, 2007 by Michael C. Gray, CPA
 
Our nation is now seeing the effects of tightening mortgage credit after a liberal period. With increases in interest rates for adjustable rate mortgages and the conversion to amortization of principal for interest-only (or negative amortization) loans, home values for homes favored by subprime borrowers are collapsing, and the debtors are either trying to "walk away" from their homes and allowing them to be foreclosed or are making "short sales".

A "short sale" is selling the home for less than the mortgage balance and trying to get the lender to forgive the unpaid balance. This is a new use of the term, and is not the definition for this item in the Internal Revenue Code. In the tax law, a "short sale" is a sale of a borrowed item to be replaced at a future date, usually a security. There are no rulings that I am aware of with the term "short sale" applied to a real estate sale.

A reason for debtors to consider a "short sale" instead of a foreclosure is to try to protect their credit history.

How are foreclosures (and deeds in lieu of foreclosure) taxed?
An important consideration in the results of a foreclosure (or a deed in lieu of foreclosure) is whether the debt is "recourse" or "nonrecourse". If the debt is "recourse", the debtor is personally liable for the debt. If the debt is "nonrecourse", the debt is only secured by the property, and the debtor is not personally liable for the balance.

You should consult with an attorney to determine the status of your mortgage. In California, most mortgages that are used to purchase a residence are nonrecourse, but mortgages from refinancing a previous mortgage are usually recourse.

When a nonrecourse mortgage is foreclosed, the property is treated as being sold for the balance of the mortgage.1 (G. Hammel, SCt, 41-1 USTC ¶ 9169.) This is important because the gain from a foreclosure of a principal residence may be eligible for the $250,000 ($500,000 for jointly-owned marital property) exclusion.

For example, for foreclosure of a nonrecourse debt,
Nonrecourse debt
$500,000
Tax basis (cost to determine tax gain or loss)
  300,000
Gain
$200,000

If the holding period requirements are met and the residence was a principal residence, the above gain would be tax-free.

(Note: The above example is for consistency and contrast with the results for recourse debt. Most non-recourse debt for a residence is purchase-money debt, and would not exceed the tax basis (purchase price) of the residence. When the residence was a replacement residence for a principal residence sold before May 7, 1997, the tax basis can be less than the cost of the residence. Most of the mortgages for residences acquired in that scenario have probably been refinanced and are now recourse debt.)
For recourse debt, the debt is only satisfied up to the fair market value of the property. There is a sale up to that amount. If the lender forgives the balance of the mortgage, there is cancellation of debt income, which is taxed as ordinary income.2 (Regulations § 1.61-12.) (But see tax relief enacted for certain recourse debt secured by a principal residence, below.)

For example, for foreclosure of a recourse debt,
Recourse debt
$500,000
Fair market value
  450,000
Cancellation of debt (ordinary income)
$ 50,000

(If the cancellation of debt was for "qualified principal residence indebtedness", it will be excluded from taxable income. If the taxpayer still owns the home after the cancellation of debt, the excluded amount will be subtracted from the tax basis of the residence. See the section on "tax relief", below.)
Fair market value
$450,000
Tax basis
  300,000
Gain
$150,000

Again, if the holding period requirements are met and the residence was a principal residence the above gain would be tax-free, but the cancellation of debt would generally be taxable as ordinary income, except for certain "qualified principal residence indebtedness." See the section on "tax relief", below.

Tax relief enacted for recourse mortgage on principal residence debt forgiveness.
Congress has passed and President Bush has approved H.R. 3648, the "Mortgage Forgiveness Debt Relief Act of 2007." The legislation is effective for discharges of indebtedness on or after January 1, 2007 and before January 1, 2010. (As I write this, the California legislature has legislative proposals to conform, but California has not yet conformed to this legislation. Check whether your state has conformed.)

Under the new law, a discharge of "qualified principal residence indebtedness" is excluded from taxable income. "Qualified principal residence indebtedness" is acquisition indebtedness secured by the principal residence of a taxpayer as defined for the deduction of residential mortgage interest, but the limit is $2,000,000 for the exclusion ($1,000,000 for the mortgage interest deduction) and $1,000,000 for married persons filing a separate return ($500,000 for the mortgage interest deduction). Also, the exclusion only applies to a mortgage secured by the principal residence of the taxpayer.

The election to exclude the income from discharge of principal residence indebtedness is made on Form 982 (Re. February 2008), Part I, lines 1.e and 2. According to IRS Publication 4681, a basis reduction amount is entered at Part II, like 10.b. only if the taxpayer still owns the residence after the debt cancellation.3 IRS Publications aren't considered legal authority and I haven't found any other authority for not making a basis adjustment when the debt cancellation happens at the same time as a foreclosure or short sale.

The exclusion does not apply if the discharge relates to providing services to the lender or any other factor not related to a decline in the value of the residence or the financial condition of the taxpayer/borrower.

According to IRS Publication 4681, if the taxpayer continues to own the home after the debt cancellation, the tax basis of the residence (cost used to determine taxable gain or loss on sale) is reduced by any amount of discharge of indebtedness excluded from taxable income, but not below zero. There is no basis adjustment if the debt cancellation happens with a foreclosure or short sale. There will be two calculations. (1) Cancellation of debt income eligible for exclusion. (2) Sale of residence to apply applicable exclusion.

The new exclusion of income for discharge of acquisition indebtedness for a principal residence takes precedence over the exclusion relating to insolvency (discussed below), unless the taxpayer elects otherwise.

For example, if the previous example for a recourse debt was eligible for the exclusion, here are the tax results:
Recourse debt
$500,000
Fair market value
  450,000
Cancellation of debt excluded from taxable income
150,000
 
Fair market value
 
$450,000
Tax basis
$300,000
 
Gain
 150,000
 

If the holding period requirements are met, the above gain would qualify for the exclusion ($500,000 married, joint or $250,000 single) for sale of a principal residence.

(Remember the foreclosure of a non-recourse mortgage is not a discharge of indebtedness, but a "sale" of the residence in satisfaction of the mortgage. Therefore, such a foreclosure won’t qualify for the new exclusion, but may qualify for the exclusion of gain for sale of a principal residence. Also, since the balance of acquisition indebtedness is almost always less than the tax basis (cost) of the residence, it would be highly unusual for there to be a gain from a foreclosure.)

What happens with a "short sale"?
Short sales are taxed under the same rules as foreclosures.
Recourse debt cancellation is not satisfied with the surrender of the property, so any debt not satisfied with the sale proceeds would be taxable as cancellation of debt income, except for certain "qualified principal residence indebtedness." See section on "tax relief" above. (Rev. Rul. 92-99, 1992-2 CB 518. Also see Treasury Regulations Section 1.1001-2(a)(2).)

Therefore, the tax consequences would be similar to the "recourse debt" example, above. The buyer and seller might also have legal concerns about whether the lender would consent to the transaction and whether (for recourse debt) the lender would in fact forgive the debt.

For example, for a recourse debt short sale,
Net sale proceeds
$450,000
Tax basis
  300,000
Gain
$150,000
 
Debt
$500,000
Pay off using net sale proceeds
  450,000
Cancellation of debt (ordinary income)
$ 50,000

(If the cancellation of debt was for "qualified principal residence indebtedness," it will be excluded from taxable income and be subtracted from the tax basis of the residence. See the section on "tax relief" above.)

For non-recourse debt short sales when the seller and buyer require the cancellation of the debt by the lender as a condition of the sale, the debt cancellation is included in the sale proceeds, like for a foreclosure.4

Therefore, a "short sale" can be a viable alternative to a foreclosure for debtors with nonrecourse debt and who qualify for the exclusion from income of the gain from the sale of a principal residence.

What about selling expenses for a recourse mortgage?
For simplicity, I have disregarded selling expenses in the above discussion. For a short sale, selling expenses reduce the sales proceeds available to reduce the loan. For a foreclosure or deed in lieu of foreclosure, selling expenses are added to the debt. (See Jerry Myers Johnson v. Commissioner, TC Memo 1999-162, affirmed CA-4, 2001-1 USTC ¶ 50,391.) The net result should be similar, assuming the fair market value of the property equals the selling price for a short sale.

For example, for foreclosure of a recourse debt,
Recourse mortgage balance
$500,000
Selling expenses
    50,000
Total debt
$550,000
Fair market value
  450,000
Cancellation of debt (ordinary income)
$100,000

(If the cancellation of debt was for "qualified principal residence indebtedness," it will be excluded from taxable income. According to IRS Publication 4681, if the cancellation of indebtedness happened relating to a short sale, no basis adjustment would be required. If the taxpayer still owned the hoome after the debt cancellation, the exclusion amount would be subtracted from the tax basis of the residence. See the section on "tax relief" above.)
Fair market value
$450,000
Tax basis
-300,000
Selling expenses
   -50,000
Gain
$100,000
 
For example, for a recourse debt short sale,
Sales price
$450,000
Selling expenses
-50,000
Tax basis
 -300,000
Gain
$100,000
 
Recourse mortgage balance
$500,000
Pay off using net sale proceeds
  ($450,000 sales price - $50,000
  selling expenses)
  400,000
Cancellation of debt (ordinary income)
$100,000
(Same caveat for "qualified principal residence indebtedness" as above.)

Other exceptions for cancellation of debt income.
Cancellation of debt income may not be taxable if the debtor is insolvent or has the debt discharged in bankruptcy.5 With recent changes in the federal bankruptcy laws, it is much harder for individuals to file bankruptcy than before the changes.

What if the fair market value of the home has dropped after purchase?
Example - Non-recourse foreclosure/short sale
Mortgage balance
$500,000
Tax basis
  700,000
Loss
-$200,000
(The fair market value of the property is disregarded for a non-recourse mortgage.)
If this is a principal residence, the loss is a non-deductible personal loss.
Example – Recourse foreclosure/short sale
Mortgage balance
$500,000
Fair market value
  450,000
Cancellation of debt income
$ 50,000

(If the cancellation of debt was for "qualified principal residence indebtedness," it will be excluded from taxable income and be subtracted from the tax basis of the residence. See section on "tax relief" above.)
Fair market value
$450,000
Tax basis
$700,000
Loss (for personal residence, non-deductible)
-250,000

Senator Grassley asks IRS to help homeowners with loan forgiveness tax bills.
Senator Chuck Grassley, R-Iowa, who is the ranking minority member on the Senate Finance Committee, has sent a letter to the Treasury Department and the Internal Revenue Service asking for help for homeowners who face big tax bills because of home loan debt forgiveness on a principal residence. Grassley asked that the IRS accept offers in compromise to eliminate or reduce the taxes for these transactions.

Grassley reminded the IRS that they may compromise to promote effective tax administration where compelling public policy or equity considerations identified by the taxpayer provide a sufficient basis for compromising the liability.

(Similar requests were ignored when taxpayers suffered tax disasters relating to stock option transactions during the stock market crash of 2000 and 2001.)

(Thanks to Richard Ogg, EA, who brought the Briarpark decision to my attention!)
For more information, there are explanations about foreclosures and cancellation of debt in IRS Publications 523, Selling Your Home; 552, Taxable and Nontaxable Income; and 544, Sales and Other Dispositions of Assets at www.irs.gov

For the latest U.S. income tax developments relating to real estate, subscribe to Michael Gray, CPA's Real Estate Tax Letter. There is no charge or obligation to subscribe to this email newsletter.
IRS Circular 230 Disclosure: As required by U.S. Treasury Regulations, you are hereby advised that any written tax advice contained on this website was not written or intended to be used (and cannot be used) by any taxpayer for the purpose of avoiding penalties that may be imposed under the U.S. Internal Revenue Code.

1 G. Hammel, SCt, 41-1 USTC ¶ 9169  return
2 Regulations § 1.61-12 ;  return
3 IRS Publication 4681, page 7.  return
4 Briarpark v. Commissioner, 5th Circuit, 99-1 US Tax Cases 99-1 ¶ 50,209, 1/6/1999; T.C. Memo 1997-298, 6/30/1997. Also see Treasury Regulations Section 1.1001-2.  ;return
5 Internal Revenue Code Sections 108(a)(1)(A) and 108(a)(1)(B)  ;return
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