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.
Posted by michaelhayley 
