Short Sales and Cancellation of Debt.
Written By
Rebecca E. Leider, CPA
www.leidercpa.com
I have learned there is so much confusion when it comes to cancellation of debt income. The first thing to understand is each person has their own unique tax situation that cannot be compared to their neighbors, friends and family. I am only covering select information in this article as there are many facts and circumstances to consider and too much information to cover every situation.
Most people don’t understand that whether the property is foreclosed or sold in a short sale, there are two things happening on the tax return. There is the sale of the property and the potential cancellation of debt income. Cancellation of debt income is the difference between the fair market value of the property minus the amount of debt owed as of the cancellation date.
We need to look at your loan to determine if there is cancellation of debt. If you purchased your residence and never refinanced the property the debt is most likely non-recourse debt. Non-Recourse means the lender can only take back the property to satisfy the debt and therefore there would be no cancellation of debt income. If the loan was ever refinanced (even if no additional monies were borrowed on the refinance) the loan is now considered Recourse debt and the lender can now pursue you personally. When the lender decides not collect for the short fall of funds, they will cancel the debt and report the transaction to the IRS on a Form 1099-C.
Next we look to see if the taxpayer qualifies for an exclusion under the Mortgage Forgiveness Debt Relief Act. The most common exclusions are:
Bankruptcy Exclusion: Debts discharged through a bankruptcy are not considered cancellation of Debt.
Insolvency Exclusion: If your debts are larger than the fair market value (FMV) of your assets, you are considered insolvent. If the FMV of your assets are $200,000 and your debts are $250,000, you are insolvent by $50,000. $50,000 could be excluded from income.
Personal Residence Exclusion: If the property qualifies as your personal residence the cancellation of debt could be excluded IF all the debt is qualified principal residence indebtedness. Monies taken out on a refinance that did not go back into the property does not qualify under this exclusion. Say you took out $50,000 on a refinance to purchase a boat and pay off credit cards. The $50,000 does not qualify as principal residence indebtedness. The IRS has a cap of $2 million in debt while California has a cap of $800,000 of debt for consideration of the personal residence exclusion.
There are different reasons to elect which exclusion to take and there could be different elections for Federal and California, based on your personal circumstance.
The most looked over fact is that because the cancellation of debt is excluded from income, it does not mean that it just goes away. The taxpayer has to lower their tax attributes or the basis of the property still owned as of January 1st of the following year or an election could be made to lower the basis of the property that was sold. This could potentially create gain on the sale of the property or you lose future tax deductions.
As I stated before, I have only covered select information, therefore you should contact your tax professional for guidance when dealing with your short sale and cancellation of debt. Publication 4681 that can be found on www.irs.gov is a great resource and has many examples in figuring gain/loss and cancellation of debt.
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