November 05, 2009

Possible tax ramifications on Short Sale or Foreclosure transactions

Posted to Kathy Mardiros

Every day the newspaper is filled with stories about homeowners and investors losing property to foreclosure or participating in a short sale transaction. What is often left out of the article is that there could be tax ramifications to the homeowner down the road in this type of transaction.

The only cancellation of debt that has no tax ramifications is a gift or bequest. There are exceptions for primary residence, if insolvent or if the debt is discharged in bankruptcy.

The rules for a primary residence are different from an investment or second home transaction. A primary residence is defined as the place where the person lives most often, what is shown on a driver’s license or voter registration, what is shown on a health insurance card or on the tax return. The person must live in the primary residence for 2 of the last 5 years.

For a primary residence you are exempt except for any cash you took out of the property – for example by refinancing. So if you purchase a property for $400,000 which is then the basis for tax purposes but refinance and now have a loan of $450,000 and the property is sold on a short sale or goes into foreclosure, there may be debt cancellation or forgiveness on the amount owed. If you have receipts for capital improvements to the property, that amount will get added to the basis before determining any tax due. If the money taken out of the property was used for personal expenses, etc. the basis will remain at $400,000 and that which is not capital improvements will be taxed as ordinary income. The lender will most likely issue a 1099C for whatever amount if forgiven. The homeowner will need to file a Form 982 to support capital improvements, etc. This form is also used if the lender forgives a portion of the amount owed changing the basis on the property.

On a primary home the tax payer/homeowner can never show a loss. A loss can be shown for tax purposes on a second home or investment property.

Other rules apply as to whether the loan is a recourse or non-recourse loan. Before considering a short sale or foreclosure action it is best to consult with your tax advisor.

Posted by:Kathy Mardiros

Tagged With: foreclosure, kathy mardiros, real estate market, short sales and tax ramifications for home owners

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