Okay, so a short sale happens and a 1099 is issued for the amount of the difference between the mortgage balance and the short sale, then reported by the homeowner to the IRS as taxable income?
So for example if the bank is owed $100,000 and agrees to accept $70,000 on a short sale, the homeowners will be paying taxes on the $30,000 difference? So, assuming that the IRS requires 10% of all income, then the homowner would only owe about $3,000?
The Mortgage Forgiveness Debt Relief Act of 2007 allows you to exclude certain cancelled debt on your principal residence from income. This is for loan forgiveness on short sales or foreclosures completed in years 2007, 2008, 2009.
Thanks Deal Hunter. How exactly does one actually explain this to the sellers as I’m pretty sure the lenders will still issue the 1099. Should it just be explained to them that their CPA will handle it and they need not worry?
Print out a Form 982, or order the pamphlet from IRS and show your sellers to dispense doubts over the 1099 issue. The documentation they will need to have as “back up” on their taxes and to show their preparer is the short sale approval letter or the Trustee’s letter if the home forecloses. Print out a Form 982 from the IRS website and keep that with their records and have it handy to make sure their preparer excludes the 1099 properly on their tax return.
Since the act does not apply to investment properties, how do you suggest these be handled? I have an abundance of investor clients who have 2, 3, 4 properties upside down in foreclosure worried about tax time for 2008. Are they able to claim insolvency? I’ve explained it that they will be 1099’d whether they short sale the properties or not - but with a short sale the difference will be less.
True - you have more control over the amount of the lender’s loss and what they will 1099 you for in a ss than in a foreclosure.
To claim insolvency against tax liabilities is a dicey game. I’ve heard some bankruptcy lawyers advise people to file the returns first and THEN file bankruptcy. This seems logical as Chapter 7 can be applied to all existing obligations. However, once you file the tax return, you almost MUST do a bankruptcy or the tax liability will get your future earnings and bank accounts attached - that could get ugly.
Another way is for the investor with multiple properties to advance these 1099’s against losses incurred in the same year as well as future NOL’s (Net Operating Loss). It will take getting your CPA or preparer to run through different profit/earnings scenarios to determine the best way to file NOLs against the tax liability. Look into tax strategies like “income splitting” and maximizing Schedule E deductions. Investors who have corporate entities have more flexibility than those that bought all their properties personally. Also, if the investor had losses from previous years, they can go back up to 3 years of NOLs to cut down this year’s tax bill.
The Act is specifically for tax liabilities (1099s given by lenders) in connection with a Primary Residence. Other deficiency judgements and 1099s (like bad personal loans) may not apply unless the tax payer’s personal residence was used for security/collateral for the loan.
There are 2 possible types of debts incurred from buying a home - Recourse and Non-recourse. Most 1st mortgages are Non-recourse, so the debt or any loss from a ss or foreclosure is wiped out with the disposition of the property. Most 2nd mortgages, however are Recourse loans (especially HELOCs), that can be transformed into revolving type credit debt and will not get wiped out with the disposition of the property. You have to determine what kind of 2nd loan you have to see if the lender can pursue you for their loss (or even the entire balance due) after a short sale or foreclosure.
Note that even recourse HELOC type loans can be “settled” for a lower amount. The nature of the settlement must be understood by the homeowner so there are no surprises down the line. Some banks will take $1000 in the short sale to “release the lien,” but will turn around and put an unsecured note for the balance due in escrow and try to make the homeowner sign it. Make your homeowners aware of this so they can be watchful for such documents at escrow.
If you get a 1099-C, the lender or bank has technically CANCELLED the debt. In the past, this was enough proof that you were “off the hook” for that debt. However, recently these so-called forgiven debts have been popping up in collection agencies and people have had to fight to get these collectors off their backs. If you can negotiate a 1099-C from the 2nd lender during your short sale process, the chances of the debt or loss being wiped is greater than if you don’t confirm that up front.
The interesting catch is this: Establised IRS code says if you recieve a 1099 for forgiven debt AND pay taxes on it, the bank can no longer go after you for the debt. So the question is, since any 1099s are exluded from taxation for 2008 and 2009, does that give banks an excuse to pursue recourse debt previously forgiven??? Only time will tell if any lenders will act on this loophole.