Short sale and income tax consequences to seller

[Todd Willhoite]

I entered into a short sale contract June 3, 2016.  The bank has taken a long time to approve and now they say we need to close in 3 weeks.  The seller is now concerned that he may have income tax liability on the amount of debt that is forgiven.  He now says he won't close.  Bank has already gotten a judgment on him.  Seller's thoughts are "I will just let it sell at sheriff's sale and then when they get their deficiency judgment I will file bankruptcy and be free and clear with no tax liability."   Does anyone know what the income tax implications are to the seller either way?  What is the motivation for the seller to sell now if he has to pay income taxes on say a $30,000 forgiveness of debt?

[Denise Evans]

The Mortgage Forgiveness Debt Relief Act might be extended through 2017.

Even if it is not, the borrower probably qualifies for the "insolvent before and after" rule.  This has long been an IRS rule, and will continue long after the Mortgage Forgiveness Debt Relief Act expires. It says that if the borrower is insolvent immediately before the debt forgiveness, and is still insolvent immediately afterwards, no taxes are due.  

If the debt forgiveness raises the borrower up into solvency status, then only the new net worth of the borrower is taxable. In other words, if the borrower had $300,000 of debts before the short sale (including mortgage, 2nd mortgage, car loans, credit cards, student loans, accrued tax liability, loans from parents or IRA, everything) and only $200,000 of assets (including FMV of home as determined by the short sale contract, equity in vehicles, so-called "sticks and stuff" being the total of all routine personal possessions, and value of retirement accounts) the the borrower is $100,000 under water or insolvent.

Bear in mind that the value of an IRA account is not the face value, but the amount left after payment of penalties and taxes and fees if the account were liquidated. Remember that unless someone owns important collections or jewelry, the value of most people's sticks and stuff is under $1,000, being what they would bring at a garage sale.

If there is $40,000 worth of debt forgiveness that leaves the borrower still $20,000 underwater, there is no tax liability.  If the result of the debt forgiveness results in the borrower now being solvent by about $5,000, taxes are due on the $5,000 only, not the $40,000 of debt forgiveness.

Virtually all homeowners in a short sale will satisfy the insolvent before and after rule.  There is no need to go through the expense and humiliation and credit score impact of a bankrupcy. That will affect his credit score LONG after the short sale or foreclosure.  In fact, a credit score rehabilitates more quickly after a short sale than after a foreclosure.

If he goes through with the short sale and has debt forgiveness, it is reported to the IRS on Form 982, available here:  https://www.irs.gov/pub/irs-pdf/f982.pdf

The borrower would check box 1(b) if relying on the insolvent before and after test. That explains to the IRS why they might receive a 1099(c) from the bank for cancellation of indebtedness income, but will not see that amount of money included anywhere on the borrower's tax return as income.  If the Mortgage Forgiveness Act is extended, the borrower must still file the same form with that year's tax return, but would instead check box 1(e). If the borrower files for bankruptcy and gets rid of the debt that way, it would check box 1(a).

Checking Box 1(b) is an audit flag, but not everybody gets audited. 

If the borrower receives an audit letter, all the IRS wants is a before and after list of assets and liabilities. This is hard to put together when in a panic over an IRS letter. It is VERY easy to do, and back up with proof if necessary, if you prepare it at the time of the short sale. No proof of values is necessary unless something is unexpectedly low. If a borrower placed a value of $500 on a late model car with no debt, he might also want to save photos of the car as a total write-off wreck, if that is the case.  Neither the lists, nor any proof, need to be sent to the IRS at the time the tax return is filed. They should be kept in that year's tax folder, however, "just in case."