Only 60 Floridians have received cash from a Bank of America (BOA) program that pays up to $20,000 to homeowners who sell distressed properties in a short sale.January 27, 2012
Q & A on IRS Debt Forgiveness on Short Sales
The Mortgage Relief Act expires December 31, 2012.
This means that anyone completing a short sale on a primary residence after this date will not be able to avoid paying income tax on the 1099 issued on the short sale amount.
General Rule for Debt Forgiveness
If a lender forgives some or all of an individual’s debts, the general rule is that the forgiven amount is treated as ordinary income and the borrower must pay tax on the forgiven amount. Exceptions apply for bankruptcy, insolvency and certain other situations, including mortgage debt.
Current Law for Mortgage Debt
(Jan. 1, 2007 through Dec. 31, 2012): A borrower can be excused from paying tax on forgiven mortgage debt. The debt must be secured by a principal residence and the total amount of the outstanding obligation may not exceed the original mortgage amount plus the cost of any improvements.
Does the relief apply only to a sale?
No. The provision has broader application. Lenders might forgive some portion of mortgage debt in a short sale (when value at sale is less than the amount owed) or in a foreclosure where the debt is wiped out. In addition, if a borrower still living in the home is able to make an arrangement with a lender that reduces the principal balance of a mortgage, the amount forgiven in that workout will not be taxed.
Can the homeowners in a short sale or foreclosure claim a loss?
No. The loss is considered a personal loss and is, therefore, ineligible for either capital loss or ordinary loss treatment.
What happens to the seller when mortgage debt is forgiven?
Until January 1, 2013, the homeowner will pay no tax on any forgiven amount
WASHINGTON – Feb. 3, 2012 – If a bank writes off debt in a short sale, it’s a “taxable event,” and the lender tells the Internal Revenue Service about the deal by submitting a “Form 1099-C, Cancellation of Debt” at the end of the year. Home sellers must acknowledge the amount when they fill out their federal taxes. Through Dec. 31, 2012, however, the federal government forgives any tax liability associated with forgiveness of a mortgage loan.
“In general, homeowners believe the government will extend this tax provision,” says San Diego Realtor Joy Bender. “However, as evidenced by the First Time Homebuyer Credit expiration in 2010, you can’t always count on the government to bail you out.”
The government generally considers forgiven debt to be income. If a seller has signed legal loan papers to take out a $200,000 mortgage and the lender accepts $100,000 in a short sale, for example, the seller received the equivalent of $100,000 in free money by government estimates. As a result, the IRS taxes it. For tax year 2012, however, the government still forgives the debt; in 2013, it might not.
The tax amount can be significant. On a debt of $100,000, a short-sale seller in the 25 percent tax bracket could end up owing $25,000 in income taxes.
Since short sales can take months and even fall through, homeowners considering a short sale may want to start the process sooner rather than later.
© 2012 Florida Realtors®
In one short year a key tax exclusion expires for home owners who close a short sale on their primary residence. The Mortgage Forgiveness Debt Relief Act of 2007 will expire on 12/31/2012. After that date, debt forgiven on a primary residence could be subject to ordinary income taxation.
I’ll make a bold prediction. The deadline is even tighter than 1+year. As someone who has negotiated with banks for over 2-years, I predict that as this deadline nears, this fact will feature prominently in bank’s negotiating strategies. Their thinking will be something like, “So, Joe Blow, you have a $100,000 net loss that will become ordinary income in 2-3 months; we will just move a bit slower and see if we can extract more blood out of you in terms”. If it were me with a big negative equity number, I’d want to have my short sale closed before mid-next year.
Trying to explain debt forgiveness taxation is beyond both my professional competence as a Realtor, and my abilities as writer. My eyes were rolling in my head just reading up on it for this piece. However, I feel comfortable quoting the IRS per (http://www.irs.gov/pub/irs-utl/pub_4702_091708.pdf):
Here are 10 facts the IRS wants you to know about Mortgage Debt Forgiveness.
1. Normally, debt forgiveness results in taxable income. However, under the Mortgage Forgiveness Debt Relief Act of 2007, you may be able to exclude up to $2 million of debt forgiven on your principal residence.
2. The limit is $1 million for a married person filing a separate return.
3. You may exclude debt reduced through mortgage restructuring, as well as mortgage debt forgiven in a foreclosure.
4. To qualify, the debt must have been used to buy, build or substantially improve your principal residence and be secured by that residence.
5. Refinanced debt proceeds used for the purpose of substantially improving your principal residence also qualify for the exclusion.
6. Proceeds of refinanced debt used for other purposes – for example, to pay off credit card debt – do not qualify for the exclusion.
7. If you qualify, claim the special exclusion by filling out Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, and attach it to your federal income tax return for the tax year in which the qualified debt was forgiven.
8. Debt forgiven on second homes, rental property, business property, credit cards or car loans do not qualify for the tax relief provision. In some cases, however, other tax relief provisions – such as insolvency – may be applicable. IRS Form 982 provides more details about these provisions.
9. If your debt is reduced or eliminated you normally will receive a year-end statement, Form 1099-C, Cancellation of Debt, from your lender. By law, this form must show the amount of debt forgiven and the fair market value of any property foreclosed.
10. Examine the Form 1099-C carefully. Notify the lender immediately if any of the information shown is incorrect. You should pay particular attention to the amount of debt forgiven in Box 2 as well as the value listed for your home in Box 7.
The following is a great article I found that discusses taxation related to common real estate taxation problems today: http://www.realestateinvestingtax.com/shortsale.shtml
This is a complex issue. If you have a negative equity position in real estate and you are thinking of doing something about it, I strongly recommend consulting with your tax expert who is familiar with the issue (not all are). I can refer someone to you if needed; just drop me a note.
A deadline is approaching that will have massive tax consequences. Since a short sale transactions take on average 4-6 months to complete, the time to act is right about now, in my opinion. Otherwise it will become a part of your opponent’s strategy.
Sometimes, I’m asked, why do you negotiate real estate loan modifications (under HAMP) when the odds of success are so low? I usually reply, but mine get approved. I’ve wondered to myself, why are the successful stats so low? (The industry average is 7%).
Perhaps my experience with a new client this week sheds some light. In looking over his papers, he applied for a modification with IndyMac, previous to now, doing it himself. Each month IndyMac sends him a form asking for year-to-date pay slips. Each month he sends IndyMac copies of his checks from his business to himself.
He is self-employed for a small construction contracting business. He doesn’t use a payroll service. He doesn’t have pay slips with year-to-date info.
The solution is simple: provide a profit and loss statement for the self-employed business. It’s an industry standard. Even the newest beginning mortgage person knows this.
The essential question is: hey, IndyMac, why couldn’t you tell this homeowner he needs a profit and loss statement rather than pay slips? Instead, IndyMac sends six monthly statements asking for a document that does not exist.
It’s not fair to ask a homeowner to think of this. How would he know?
Hey IndyMac, why are your success odds for HAMP about 7%?
Here is another tough question: is your low success rate on purpose or is it just bureaucratic incompetence?
I’ve seen very few home owners successfully modify their loan themselves without professional help. The odds are not very good for most homeowners to successfully do-it-yourself (DIY) and modify their own loans. DIY modifications might account for the 7% national success rate for the HAMP modification program. See: http://realtyinfusion.tumblr.com/post/352453167/hamp-statistics-7-percent-success-rate
Here 9 reasons why I feel a professional negotiator can produce success for modifications under HAMP and other programs:
- An experienced negotiator will begin developing his strategy by looking at the loan documents seeking evidence of TIL, RESPA and HOEPA violations. Very high percentages of loans originated in 2004-2009 have documentation and regulatory problems. Add to this appraisal problems, no-income-verified excesses, and predatory lending terms. The legal and regulatory remedies available are huge. They give very strong negotiating advantages. We use a forensic audit to establish this proof. Our attorneys are ready with Qualified Written Request forms and Notification of Violation letters which cite case-law and requested remedies.
- An experienced negotiator knows the math under the available programs and knows specifically what terms to ask for.
- An experienced negotiator knows the major programs, has full copies of the program rules and documents his cases to comply with the rules.
- A home owner is susceptible to emotions in a negotiation. Bank’s carefully train collections and Loss mitigation people to push emotional buttons, and they are very good at it. A professional negotiator is more businesslike, and lacks the direct emotional involvement of the homeowner. We can play the game too by pushing emotional buttons of the lender’s negotiator.
- An experienced negotiator knows how to document a file properly to build a case each step of the way. We ask for employee name, employee number at every conversation. Every contact is usually followed by an email/fax/letter that is friendly in tone, but has the “just to confirm our understanding, …and you agreed to do … by ”. We note every contact with the lender and summarize it in the file. The the client is copied via email on the notes. Every written communication contains a summary statement of what we are asking for under the modification program. We make and document lender contact a minimum of 2x a week.
- An experienced negotiator knows how to navigate lender’s phone systems to get a live person and what to say to get a decision maker or supervisor.
- An experienced negotiator has the lender’s own specific paperwork and knows how to complete it. He subscribes on Internet forums that discuss the lenders and their typical actions.
- An experienced negotiator knows how to resolve problems. Are other debts too high? Can we try debt counseling or debt settlement plans? Income too low: can we add another occupant’s income, or document support by a son or daughter? Are we documenting income in the most favorable light? Can we show deposits to show the self-employed business is making more cash that the P&L’s show? Every case has a flaw of some sort; knowledgeable negotiators develop and document strategies to offset flaws.
- An experienced negotiator knows how to properly meet documentation requirements during trial periods so the modification becomes permanent.