DISCLAIMER: We are not Certified Public Accountants (CPAs) and you should always see a qualified tax professional to understand the tax implications as they pertain to your specific situation. The following sections are intended to illustrate common situations and should not be relied upon as specific advice. If you need the name of a good accountant in this area, please Contact me and we will gladly point you in the right direction.
One of the biggest questions around a short sale has to do with the tax consequences associated with short sales. Traditionally, the taxation authorities have considered any write-down of debt (cancellation of debt) as “ordinary income”. That means a $100,000 write-down by the bank to allow the short sale would add $100,000 in income for the year for taxation purposes by California or the IRS.
Clearly, someone who can not afford to make their house payments will not be able to afford an additional $20k – $40k in taxes following the event. For that reason, the IRS and California Franchise Tax board now have laws in effect that are primarily for the protection of short sale consequences on principal residences. Those laws are temporary and listed below for your reference:
An additional component has to do with whether the final sale price still exceeds the original purchase amount, also adding “capital gains”. Take the example where an individual purchases the property for $300k, refinances a loan value of $500k and eventually short sells for $350k. Under this simplified scenario, the seller would have a debt cancellation of $150k ($500k loan – $350k sale proceeds) and a capital gains exposure of $50k ($350k sale – $300k purchase). For capital gains amounts, as a primary residence the home would still qualify for capital gains exemptions ($250k individual, $500k married).
Income-Producing (Rental) Properties
Clearly, the existing governmental protections are written for the protection of primary residences and not income-producing properties. However, there are existing laws that often may be leveraged to offset or avoid tax implications on these properties. Ordinary losses and passive activity losses may be used to partially or completely offset the associated income as available. Insolvency (having more debt than assets) may also be used up to the insovency balance for a partial or complete offset. Losses from other businesses and investments might be applied or the income from debt cancellation might be deferred for several years. Don’t forget that any applicable depreciation that has been claimed in previous years may need to also be recaptured and accounted for in the final analysis. Needless to say, the implications associated with a rental property need to be fully thought through with a well-qualified tax professional, who could make a big difference in identifying the best options to offset or defer otherwise taxable “income”.
From a tax perspective, foreclosure of a principal residence has very similar consequences as a short sale. While there is no “write-down”, the home is considered to have been sold for the balance of the existing mortgage. If the home has not been refinanced, it usually has no implications because the mortgage balance will not be greater than the original purchase amount. Keep in mind that this might not be true because some loan programs allowed balances to actually increase (such as “pick-a-pay” loans), or if the home is left in the foreclosure process for an extended time the balance is increased by the missed principal, interest, and imposed fees. If the balance does exceed the original purchase amount, the homeowner will usually still be protected by the current capital gains exemptions if it is their primary residence (again $250k individual, $500k married). On loans that have been refinanced for increased balances, this exemption usually still applies, providing tax protection above the original purchase price up to the exemption amounts.