When Payments Can’t Be Made – Short Sales

July 7, 2011

In today’s economic crisis, many homeowners who purchased homes in the past five to 10 years are finding that their homes are now worth less than what they’re paying on monthly mortgage payments.  Some people are continuing to pay on the mortgage, hoping for an eventual uptick in the housing market.  Others have had no choice but to let their homes be foreclosed upon, taking a credit hit and hoping to regain a savings to move to a place they can better afford for the long-term.  There is also a third option that some people are taking – short selling their home.

What is a short sale?

Short selling (or a short sale) is the process of selling a home where the sale proceeds fall short of the balance owed on the property’s mortgage(s).  Negotiating a short sale is a unique real estate transaction involving negotiations between the seller, the mortgage company, and the buyer.  Short sales often occur when a homeowner can no longer pay the mortgage loan on their property, but the lender decides that selling the property at a loss is better trying to get money from the borrower.  Both parties must consent to the short sale process, allowing them to avoid foreclosure, which involves hefty fees for the bank and poorer credit report outcomes for the borrower. 

Short sales have financial ramifications that go well beyond the impact on a credit score and ability to qualify for a mortgage. Some states, known as recourse states, allow lenders to collect deficiency balances from the borrower after the transaction closes. Lenders can ultimately pursue a deficiency judgment, which could force short sellers who can’t pay the difference into bankruptcy.   Most short sales now include an agreement from the lender not to pursue the deficiency balance.

Tax Implications of a short sale

In the case that the short sale deficiency is forgiven, or the borrower lives in state where deficiencies cannot be recovered, the IRS may be next in line for their money. The IRS does consider forgiven debt to be taxable income. One piece of good news: as a result of the financial crisis, Congress enacted the Mortgage Debt Relief Act of 2007.  The Act allows taxpayers to exclude up to $2 million (if married filing jointly) of income from the cancellation of debt on their principal residence in 2007 through 2012.  Debt reduced through mortgage restructuring (loan modification), as well as mortgage debt forgiven in connection with a short sale, qualifies for the relief.   All forgiven debt must be reported on IRS Form 982 and attached to your tax return.  Second homes and investment properties do not qualify for the Mortgage Debt Relief Act and any cancellation of debt may be taxable.

If you are living in Los Angeles  and are interested in getting in touch with a CPA, then get in touch with us.