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The Tax Aspects of Short Sales

By Robert D. Grossman, Jr. Esq.

Generally, gross income includes any amount of discharged indebtedness. The rationale behind the income inclusion is that because the original loan proceeds were not taxable upon receipt by the borrower, the proceeds are taxable to him in the year his loan is discharged and he does not have to repay his debt.

Notwithstanding the general rule that discharge of debt is income in the year of discharge, Internal Revenue Code (hereinafter “Code”) §108 provides an exception for certain specifically enumerated discharges of debt.

Pursuant to Code §108(a)(1)(E) one of those exceptions is for the discharge of “qualified principal residence indebtedness” occurring after 2006 and discharged before January 1, 2013. The Mortgage Debt Relief Act of 2007 was enacted on December 20, 2007. Generally, the Act allows exclusion of income realized as a result of modification of the terms of a mortgage or foreclosure (hereinafter called “short sale) of “qualified principal residence indebtedness”.

The term “qualified principal residence indebtedness” means “acquisition indebtedness” in respect of the principal residence of the taxpayer in an amount of not more than $2,000,000. Code §108(h)(2).

The term “acquisition indebtedness” means any debt incurred in acquiring, construction or substantially improving a taxpayer’s principal residence if such residence secures the debt i.e. the residence is collateral security for repayment of the loan (mortgage or trust).

The term “principal residence” means residential property if, during the 5–year period ending on the date of the short sale or loan modification, such property has been owned and used by the taxpayer his principal residence for at least two years. Code §108(h) and §121(a).

The exception for exclusion of income on a short sale or loan modification of a qualified principal residence does not apply to a discharge of a loan if the discharge is on account of services performed by taxpayer for the lender or any other factor not directly related to a decline in the value of the residence or the financial condition of the taxpayer. Code §108(h)(2).

Notwithstanding the above, the Mortgage Forgiveness Debt Relief Act of 2007 does not apply to all forgiven or cancelled debt. As stated above, the Act only applies to forgiven or cancelled debt used to buy, build, or substantially improve the principal residence or to refinance debt incurred for that purpose. Debt used to refinance a residence qualifies for this inclusion but only up to the extent that the principal of the old mortgage immediately before the refinancing would have qualified. This means that refinanced debt in a greater amount than the original mortgage does NOT qualify for exclusion from income to the extent it is greater than the original debt. An example may be helpful. 

In 2002, Becky purchases a principal residence for $315,000 and borrows $300,000. She made a down payment of $15,000. The loan was secured by the residence. In 2003, Becky took out another loan in the amount of $50,000 to add a garage to her residence. In 2008, when the principal balance of her loans was $325,000, Becky refinanced the two loans for $400,000 (assume the fair market value of her residence then was sufficient to secure such a loan. She used the additional $75,000 ($400,000 loan less $325,000 combined debt from her prior qualified residence loans) to pay for personal credit cards and send her daughter to college. 

After this refinance, her “qualified principal residence” debt is $325,000 because the debt resulting from her refinancing is “qualified principal residence debt” only to the extent the amount of the new debt does not exceed the amount of her refinanced “qualified principal residence” debt. 

The Mortgage Forgiveness Debt Relief Act of 2007 applies to qualified debt forgiven in 2007, 2008 or 2009. The Emergency Economic Stabilization Act of 2008 extended the treatment to the year 2012.

If debt is forgiven, a taxpayer must nonetheless include and report that forgiveness on his tax return. The amount of the debt forgiven must be reported on Form 982, copy attached, which form must be attached to the taxpayer’s tax return for the year of the short sale.

The taxpayer’s lender should send taxpayer a Form 1099-C, Cancellation of Debt, to the taxpayer by January 31 of the next year succeeding the year of forgiveness.

The amount of debt forgiven or cancelled should be shown on Form 982, Boxes 1e and 2. The debt forgiven on a second home, credit card or car loan is not excluded from income nor covered by Code §108. As stated above, only cancelled debt used to buy, build or improve a principal residence or the refinanced debt incurred for that purpose and subject to the above qualifies for exclusion under Code §108(a)(1)(E).

However, the part of the forgiven debt that does not qualify for exclusion from income under Code §108 (a)(1)(E) (principal residence indebtedness), may still qualify for exclusion under a different provision of Code §108.

Such nonqualifying principal residence debt may nonetheless qualify for income exclusion under the insolvency “exclusion” of Code §108. Normally a taxpayer is not required to include forgiven debt to the extent the taxpayer is insolvent. Code §108 (a)(1)(B). A taxpayer is insolvent if his total liabilities exceed his total assets. Forgiven debt may also qualify for Code §108 exclusion if the debt was discharged in a bankruptcy proceeding (Code §108 (a)(1)(A) or stems from “qualified farm indebtedness”(Code §108(a)(1)(C) or “qualified real property business indebtedness” (Code 108(a)(1)(D).

About the Author

Robert D. Grossman, Jr. is a tax attorney in Las Vegas, Nevada. He is a member of the State Bar of Nevada. He has a B.A. in Economics from the University of Virginia, a Juris Doctor degree from the University of Florida and an LLM (Master of Laws) in Taxation from N.Y.U. He was formerly a trial attorney for the IRS, Office of Chief Counsel, Tax Court Litigation Division, Trial Branch, in Washington D.C. He left that office as a Senior Trial Attorney. He has been in his own law practice for the last 36 years where he represents taxpayers before IRS and in tax planning.