[The following is NOT legal advice. For legal advice and counsel, you must consult an attorney or in this instance some other tax professional, and not a blog.]
Later today — if he has not done so already — President Obama will sign legislation avoiding the “fiscal cliff” for at least another month or two. (Insert rolled eyes here — is it really in the nation’s best interests to repeatedly address our financial issues on a temporary and piecemeal basis?) This legislation includes fantastic news for sellers here in the State of Washington: The principal residence exemption to cancellation of debt income has been extended until the end of 2013 (see Section 202 of the act, link above).
Primary Residence Exclusion to Cancellation of Debt Income Tax – Background
Before I go further, here is a brief primer on the issue. Generally speaking, the IRS considers as income any forgiven debt (Cancellation of Debt, or COD, income). For example, if I borrowed $50k from you, that money would not be “income” subject to taxation because, while I received $50k from you, I had a corresponding liability to repay you in the same amount. But if a year later you released me from the obligation and forgave the balance of the debt when I still owed you $40k (after paying down the debt by $10k), then at that moment I would have realized $40k in “income.” This is because in the eyes of the IRS, when I no longer am legally required to repay the balance of the loan, that amount is considered income for the year in which the debt was forgiven. Therefore I would need to report this “income” — $40k, the amount of the forgiven debt — on that year’s federal income tax return (and of course pay taxes on it).
In 2007, as the housing crisis was getting underway, Congress passed the Mortgage Forgiveness Debt Relief Act. This act allows homeowners to avoid COD tax liability on debt that was incurred with the purchase of a principal residence (“acquisition debt”). In other words, if the property is your principal residence, then you will not face income tax liability on the forgiven portion of the debt that you incurred when you purchased the house (if you refinanced then you will still be subject to tax liability on the debt in excess of the acquisition debt).
Here in WA, there is debate about the COD tax implications of a non-judicial foreclosure. The vast majority of foreclosures in this state are of this variety. In a non-judicial foreclosure, the difference between the funds paid at the foreclosure auction and the amount owed is extinguished as a matter of law. In other words, following a nonjudicial foreclosure, the owner/debtor neither owns the house nor owes any money to the bank, regardless of what was paid for the property at auction. Accordingly, some — but not all — experts believe that a nonjudicial foreclosure does not create COD tax liability. Thus, an owner/debtor subjected to a nonjudicial foreclosure at least has an argument that he does not have COD tax liability as a result.
But a short sale? There is no question that debt forgiven as part of an approved short sale is subject to COD tax liability absent the “principal residence” exemption. For example, if your house sells for $300k but you owe $400k, and assuming your lender relieves you of the obligation to repay the $100k difference, then you will have to report $100k as income resulting in a tax bill of an additional $30k or so (depending on your tax bracket). That would — or should — strongly discourage sellers from seeking a short sale as opposed to letting the home go to foreclosure.
But thankfully sellers don’t have to “crunch the numbers” to determine whether a short sale is in their financial interests as opposed to foreclosure. With extension of the “principal residence exemption” every short seller of a principal residence in 2013 will be able to avoid tax liability on the forgiven acquisition debt. Hooray! And if you listen closely, you can hear the cheers from those folks who focus on facilitating short sales… :-)
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- Puget Sound Housing Market: Good News is Just Around the Corner!
- The Short Sale Hardship Letter: What Is It? Why Is It Important? How Do I Write It?