Tax Implications of a Short Sale

General Real Estate Investing
1

Investor pays $100,000 for a property. 100% financing.

Rents it two years and mortgage goes into default.

Mortgage company agrees to a short sale willing to accept $70,000 for the $95000 owed.

What is his the owner’s basis for calculating his gain or loss (generally speaking…I know depreciation taken, etc. affects basis, I am just interested in the effect of the short sale and 1099-C income)?

Is it the 95 because of the forgiven debt? Or would it be $70 where he would at least partially offset the have a long term capital loss?

2

I don’t have a certain answer, but I spoke with a r/e agent who use to manage short sales for a bank and he said that whatever the loss is for the bank is the gain for the owner, therefore, using your example:

95K minus 75K = 20K in taxable gain by the owner via 1099.

Am I correct?

3

cancelled debt reduces your basis (and therefore increases income equally)

the good news is that in this case the cancelled debt will be taxed at capital rather than ordinary rates.

I think there’s a form for this (982 maybe?) that attaches to your Sch C.

4

Since the debt in question is recourse debt, you have two calculations to perform. Using the numbers in your example, and, assuming that the adjusted basis is $95K:

  1. Sale Price - Adjusted Basis = Gain (Loss) on Sale
    $70K - $95K = $25K capital loss

  2. Recourse Debt - Sale Price = Cancellation of Debt Income
    $95K - $70K = $25K COD Income

In your example, the debtor has both a capital loss and COD Income (taxed as ordinary income).

If the debtor is in bankruptcy, or insolvent, the COD income is excluded from taxable income. Thus, in this example, the insolvent taxpayer would report a capital loss but would not have any taxable income from the forgiven debt.

The problem for the solvent taxpayer, is that the cancellation of indebtedness creates an income tax liability but the short sale did not produce any cash flow to pay the taxes. The cancellation of indebtedness is really a “phantom” income.

Instead of reporting the COD Income as taxable income in the tax year the debt is forgiven, the solvent taxpayer could elect to reduce the basis in (other) depreciable property by the amount of his COD Income (Form 982), as long as the basis is not reduced below zero. As Mark already mentioned, this strategy converts the COD from ordinary income to a (perhaps future) capital gain (which could be indefinitely deferred with a 1031 exchange).

Just how this layman sees it.

5

Dave T,

Thanks, makes perfectly good sense to me.

So, just to say that Form 982 allows one to reduce his basis is not entirely correct.

982 allows one to reduce the basis of “OTHER” “depreciable real property”.

So, an individual homeowner who owns no other depr. realty would not benefit from nor have reason to file Form 982.

He would then report the 1099-C as Other Income and use the Capital loss to offset capital gains or other income based on capital loss limitations. Based on our example, it would take the taxpayer literally 8+ years to fully benefit from the capital loss.

Thanks again.

6

Not quite the way I understand the concept, though I admit my understanding could be flawed.

That said, the taxpayer does not have to reduce the basis in any depreciable property, the Form 982 election is optional.

Should the taxpayer elect the basis reduction option, the depreciable property selected does not have to be the property involved in the short sale. It could also be any other depreciable property held by the taxpayer.

And, remember that the insolvent taxpayer is not required to include forgiven debt in his taxable income. Since the investor in your example has already defaulted on his mortgage, I tend to suspect that this investor is insolvent.