Selling at a Loss? Here's What to Expect From the IRS.
By Bill BischoffSmartmoney.com
It's a homeowner's worst nightmare: selling a home at a loss. Sadly, with the real estate market slowing, more folks are discovering that, yes, this can actually happen.
The worst-case scenarios occur when folks borrowed heavily to buy at the top of the market or took out big home-equity loans while prices were inflating -- two situations that can result in the mortgage debt exceeding the value of the home. And if homeowners in these situations have to sell, not only will they owe money to the bank but there could be some unexpected income tax consequences.
A home sale where the mortgage debt exceeds the net sale price (after subtracting out commissions and other transaction costs) is often called a short sale. If you find yourself in this situation, here's what you need to know about the federal income tax implications of short sales.
The subject is complicated. The easiest way to explain matters is with some examples.
Example 1: Say you paid $260,000 for a home that you can now sell for a net sale price of $300,000. Unfortunately, you also have $350,000 of first and second mortgages against the property. For tax purposes, you will have a $40,000 gain if you sell because the price exceeds your tax basis in the home ($300,000 sale price minus $260,000 basis equals $40,000 gain). The Internal Revenue Service doesn't care that you're still $50,000 in the red after the sale ($350,000 of debt vs. the $300,000 sale price). The bottom line is that you can have a tax gain without any cash to show for it.
The good news is that you will probably qualify to exclude the $40,000 gain for federal income tax purposes thanks to the home-sale-gain exclusion. So the sale probably won't trigger a federal tax bill. Depending on where you live, there may or may not be a state income tax hit.
Example 2: You can also have a short sale where the net sale price is less than what you paid for the home.
Say you paid $340,000 for a home that you can now sell for a net price of $300,000. You also have $350,000 in first and second mortgages against the property. For tax purposes, you will have a $40,000 loss if you sell because the sale price is lower than your tax basis in the home.
Will the IRS let you claim a write-off for the loss? No. You can claim a tax loss only on investment property. A loss on a personal residence is considered a nondeductible personal expense for federal income tax purposes. Most states follow the same principle.
Now, what about that $50,000 that you still owe the mortgage lender in both of these examples? Good question. In most cases, the lender won't let you off the hook for any of the debt. You will have to figure out a way to pay it off, and you won't get any tax breaks for doing so.
If you're more fortunate, the lender could decide to forgive some or all of the unpaid $50,000. (This may happen if the lender thinks it's unlikely you will be able to repay the full amount.) To the extent debt is forgiven, you have what is called debt discharge income (DDI) for tax purposes. Here's what happens with that:
The general rule is that DDI is taxable income. For the year of the DDI, the lender should report the amount to you (and to the IRS) on Form 1099-C. You generally must report the DDI as income on your return for that year.
There are some exceptions to the general rule that DDI is taxable.
If the borrower is in bankruptcy proceedings when the DDI occurs, it is excluded from taxation.
If the borrower is insolvent (which means debt exceeds the value of assets), the DDI is entirely excluded from taxation as long as the borrower is still insolvent after the DDI occurs. If the DDI causes you to become solvent, part of the DDI will be taxable (to the extent that it causes solvency). The rest will be excluded from taxation.
To the extent that DDI consists of unpaid mortgage interest that was added to the loan principal and then forgiven, the forgiven interest that you could have deducted (had you paid it) is excluded from taxation.
If the DDI is from seller-financed debt (mortgage debt owed to the previous owner of the property), it is excluded from taxation. However, your basis in the property must be reduced by the amount of excluded DDI. If you then sell the property for a gain, the gain will be that much bigger. As explained earlier, however, you can probably exclude the gain under the home-sale-gain exclusion.
What About Foreclosure?
Say your property is foreclosed (or transferred to the lender via a deed in lieu of foreclosure). When the mortgage debt exceeds the property's fair market value, the transaction is treated as a sale for a price equal to fair market value. Naturally, the sale will trigger a tax gain if the market value exceeds your tax basis in the home. Once again, however, you can probably exclude the gain under the home-sale-gain exclusion rule.
If the lender then forgives all or part of the difference between the higher amount of the mortgage debt and the lower market value of the home, the forgiven amount is DDI and is taxable unless one of the exceptions explained earlier applies.
Here's another example to help bring things into focus:
Example 3: Say you borrowed against your home when local property values were rising steadily. The chickens came home to roost, and the bank foreclosed. Assume its market value was $300,000 at the time of the foreclosure. Your tax basis in the home was $260,000. The property was burdened by a $200,000 first mortgage and a $150,000 second mortgage (total debt of $350,000).
Assume that the full $200,000 first mortgage balance and $100,000 of the second mortgage principal get paid off when the lender sells the property. You manage to scrape together $10,000 to pay off part of the remaining second mortgage balance. The lender forgives the last $40,000. Here are the federal income tax results:
The foreclosure triggers a gain of $40,000 ($300,000 market value minus $260,000 tax basis equals $40,000). Assuming you qualify, the gain can be eliminated by the home-sale-gain exclusion. The second mortgage lender's forgiveness transaction triggers $40,000 of DDI. That amount must be reported as income on your tax return, unless one of the exceptions explained earlier applies.
The important thing to understand here is that a real estate short sale or foreclosure can potentially result in a taxable gain or taxable DDI. That's the bad news. The good news is that you can probably exclude the gain from taxation, and you might be able to exclude some or all of the DDI, too.