How Are Foreclosures Handled on Tax Consequences & Short Sales?
- In 2007, the U.S. government approved the Mortgage Debt Forgiveness Relief Act, providing distressed homeowners with a level of taxation protection in the event of a foreclosure or short sale for the six-year period ending in 2012. Prior to the Act, forgiven debt from a short sale or foreclosure was counted as income and taxed at the homeowner's current rate. However, the MDFRA allows sellers to exclude as taxable income any primary mortgage debt that's forgiven as a result of foreclosure, short sale, and mortgage restructuring.
- "Primary mortgage" is the operative term. If you're defaulting on a mortgage that's tied to a second home, the MDFRA doesn't apply, and any forgiven balance is subject to taxation. However, if you're insolvent --- meaning, your outstanding debts were greater than your assets at the time of the sale --- you may be able to exclude this "income" from taxation.
The MDFRA will only forgive mortgage debts up to two million dollars. In addition, if there is a second lien on the home that's forgiven, the debt must have been used to "acquire, build, or improve" the primary residence. - In short sales and foreclosures, the debt discharge income is that amount that's forgiven on the mortgage. For example, if you owe $250,000 on your home but it sold for only $200,000 and the home was foreclosed (or you did a short sale), the amount of the debt discharge is $50,000 (the "DDI"). The DDI must be reported on your income tax return, even if it is not subject to taxation under the MDFRA. If you are pursuing a short sale or foreclosure and reporting DDI on your tax return, be advised that you may not also claim a loss on the sale.
- If you have declared bankruptcy or are insolvent, then DDI is non-taxable. Both bankruptcy and insolvency necessitate the use of a taxation or legal professional. Insolvency can be particularly tricky, since the timing of the sale and the amount of debt at the time must be coordinated. There are also special rules regarding when a home sale results in insolvency, which generally state that a portion of the debt may be excluded. Don't miss the forest for the trees. Have a professional review your personal situation, and you can put the ugly mess behind you.
