Tax Rules Encourage Short Sales Sooner, Rather than Later

Tax rules that let you escape paying federal income tax after a short sale expire this year.

Update: Congress extended mortgage cancellation relief through the end of 2013. So home owners who have a portion of their mortgage forgiven as part of a workout plan, short sale, or foreclosure before Jan. 1, 2014, won’t have to pay income tax on the forgiven amount.

If you can’t afford your mortgage and know you’re going to eventually have to sell your home via short sale, you might want to get going on that sooner rather than later.

If you complete your short sale in 2012, you won’t owe federal taxes on the transaction. If you wait until 2013, you could owe a hefty federal tax.

In a short sale, the lender lets you sell your house for less than what you owe on the mortgage.

For example:

  • You have $200,000 left on your mortgage.
  • You can sell your house for $150,000.
  • Your lender agrees to let you sell the house and takes $150,000 instead of the $200,000 you owe.
  • Your lender forgives the $50,000 difference between the $200,000 you owe and the $150,000 you sold your house for.

If you did the short sale in this example this year, you wouldn’t owe taxes on the $50,000 the lender forgave. That’s because in 2007 and again in 2008, Congress told the IRS to stop collecting taxes on forgiven debt until 2013.

Before the 2007 law passed, you had to pay federal income tax on forgiven debt. If your lender forgave $50,000, the IRS said that $50,000 was income. If you were in a 28% tax bracket you’d owe $14,000 (.28 x $50,000) in federal income taxes.

Here we are 12 months away from the deadline, and it’s anybody’s guess whether Congress will renew that no-taxes-on-forgiven-debt rule. It’s just one of literally trillions of dollars of tax benefits expiring at the end of this year, and there’s no signal yet as to what, if anything, Congress will do about any of them.

And if that’s not confusing enough, states have their own tax laws on debt forgiveness that you have to consider, too.

Silver tax lining for 2013?

If you end up having to short sale in 2013, you may be able to avoid taxes another way. If what you owe all your creditors exceeds the value of everything you own, you may not owe tax. Read about the insolvency rule in Publication 4681. (Note: The IRS includes all your assets in determining if you’re insolvent before the short sale.)

Despite its name, a short sale often takes a long time to complete. To ensure you have short sale success before the tax rule changes, work with a real estate agent who has done short sales, promptly give your lender any paperwork it asks for, and pray for patience. You’ll need it.

Did you buy or sell in a short sale? How long did your transaction take?