Short Sale Tax Consequences: Understanding The Qualified Principal Residence Exemption

As we approach the tax filing deadline, the Internal Revenue Service is reminding taxpayers that any canceled debt following a short sale, foreclosure or restructuring of a mortgage must be treated as taxable income unless you qualify for an exemption.  In general, when a creditor cancels debt, such as unpaid balances on student loans or credit cards, the forgiven amounts are treated as ordinary, taxable income by the Internal Revenue Code. The Mortgage Forgiveness Debt Relief Act of 2007 , however, provides a homeowners with various exemptions. Most notably, The Debt Relief Act provides an exemption for any debt canceled by the lender which was used “to buy, build or substantially improve your principal residence“. Due to the overabundance of foreclosures and short sales, the IRS recently issued guidance instructing former homeowners as to whether their canceled mortgage debt must be reported as taxable income.

 

As someone who exclusively deals with the disposition of distressed properties, I can attest that the treatment of canceled mortgage debt is one of the most widely misunderstood aspects of short sales and foreclosures.  A simple mis-calculation of tax liability, or a general misunderstanding of the tax law, costs consumers billions of dollars of tax liability every year. For this reason, it is important to understand how you can avoid getting hit with additional taxes and whether you qualify for a tax exemption following a short sale or foreclosure.

 

The IRS focuses on several key points that homeowners and real estate professionals need to know.  Surprisingly, many Realtors with whom I work are mistakenly under the impression that the homeowner automatically qualifies for the tax exemption if a lender writes off the mortgage debt of their primary residence. This is incorrect. There are specific requirements that need to be met in order to qualify for the tax exemption. Most notably, the debt canceled by the lender must have been used “to buy, build or substantially improve your principal residence.”

 

The cancellation of debt provision, commonly referred to as the ‘qualified principal residence exception’, does not apply to your second home, an investment condo, a weekend retreat or a seasonal home you occupy for less than half the year. It can only be your main residence and you will need the documents to prove it.  Proving that the house is your primary residence is the easy part. The house also needs to be your qualified principal residence.

 

In order to be considered your qualified principal residence, the unpaid mortgage balance your lender canceled as part of a modification, short sale or foreclosure cannot have been used for something other than acquiring or constructing the house or making capital improvements to it. As a result, if you were amongst the millions of Americans who took advantage of historically low interest rates and refinanced your home, you likely will not qualify for the tax exemption unless the refinance proceeds were used to make substantial home improvements. In addition, refinanced mortgage debt used for tuition, vacations, buying cars or paying off credit card bills will not pass the test. As you can imagine, many people erroneously assume, or are incorrectly advised, that they will qualify for the tax exemption simply because the home was their primary residence, while in fact they are disqualified from the full exemption because they refinanced their primary residence in order to pay off debts.

 

The IRS offers a hypothetical example of how a simple refinance of your primary residence can affect your eligibility for tax relief: A taxpayer took out a first mortgage of $800,000 when he bought his home years ago. Thanks to strong appreciation, the house was soon worth $1 million and the owner refinanced the mortgage to $850,000. The loan balance at the time of the refi was down to $740,000, and the owner used the $110,000 in cash-out proceeds to buy a new car and pay off credit card debts.

 

Bad move. A year or two later — presumably well into the recession and housing bust — the home value had plunged to between $700,000 and $750,000. The owner then persuaded his bank to allow a short sale for $735,000 and to cancel the remaining $115,000 of unpaid debt.

 

Does the owner get tax relief on the full $115,000 under Congress’ special exemption? No way, according to the IRS. He escapes income taxes on just $5,000 of the $115,000 because he spent the other $110,000 on a car and credit card balances — neither of which counts as “qualified principal residence” debt.

 

The IRS is also warning taxpayers who may have unknowingly converted their qualified principal residence that they too may be subject to unexpected tax consequences. Those who walked away from their houses may be liable for taxes if, at some point, the property “no longer was their primary residence” — say they rented it out after their last payment and before the foreclosure — effectively converting the house into rental property, not their principal home. Likewise, if a homeowner vacated their property and rented it out prior to a short sale, this may also disqualify you from the protections afforded under the Debt Relief Act.

 

As illustrated above, the cancellation of debt tax rules are complicated and the IRS is encouraging individuals to seek assistance from a licensed tax professional if you recently lost a home to foreclosure or completed a short sale.  For more information on The Debt Relief Act, continue reading here or go to IRS.gov to download the appropriate forms. Lenders who write off unpaid mortgage balances are required to provide borrowers with a year-end IRS form 1099-C cancellation of debt statement, including the amount of the loan forgiven and the fair market value of the property. If you had mortgage debt canceled but haven’t received a 1099-C from your lender, you should immediately request it in order to avoid federal tax hassles. As always, anyone facing foreclosure should always seek the advice of an independent tax professional prior to agreeing to a short sale in order to assess whether you qualify for any tax exemptions under the Mortgage Forgiveness Debt Relief Act of 2007.

 

Excerpts from The Los Angeles Times

 

About the Author: Greater Boston Short Sales, LLC (GBSS) is Massachusetts’ leading short sale negotiator. GBSS assists homeowners, Realtors and attorneys with getting their short sales closed. Contact us today if you are a homeowner facing foreclosure or a Realtor seeking assistance with a short sale transaction. GBSS is a MARS provider. Please read our disclaimer HERE.

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