Short Sales, Foreclosures & Pending Tax Changes

If Congress doesn’t act immediately on extending current legislation the Mortgage Forgiveness Debt Relief Act of 2007 will expire December 31rst. This factor will have serious tax consequences for homeowners that undergo foreclosures or sell their homes via a short sale beginning January 1rst 2013.

A short sale allows a homeowner to sell, with the lender’s agreement, their home for less than what is owed on the loan in a move intended to avoid foreclosure. The difference between the amount owed and the selling price is considered “forgiven debt.” The same holds true on foreclosed properties or loan modifications where the principal is reduced. Prior to 2007 IRS tax codes required that homeowners include any forgiven debt as part of their taxable income.

The 2007 DRA law allows taxpayers to exclude from taxable income the amount of debt that is forgiven or canceled by their lenders. For example: if the outstanding loan amount is $300,000 and the homeowner does a short sale for $250,000 the homeowner would have to declare the forgiven debt of $50,000 as income. If the homeowner were in a 30% tax bracket then they would have an additional $15,000 tax burden.

When looking at a RealtyTrac report ( Q3 2012 U.S. Foreclosure & Short Sales Report™) for all short sales, the average selling price was $94,896 below the mortgage on the property during the third quarter. Now that would be a serious tax penalty if Congress doesn’t act.

Many believe that Congress will act in this late hour to extend the legislation, but with all the political maneuvering over the national budget and the pending “fiscal cliff” there is no guarantee that Congress will act in a timely manner.

Fortunately many homeowners acted to avoid this tax time bomb by moving to transact the short sale earlier in the year. According to Renwood RealtyTrac LLC short sale transactions increased by 35 percent in the third quarter from one year earlier giving indication that underwater homeowners were acting to avoid the potential penalties. During the same period sales of bank-owned homes dropped 20 percent.