Seller Taxed On Short Sale?

Hi, I'm not sure about this, but i heard that when you do a short sale, the difference of equity that you created by doing the short sale is taxable when you sell it, but it is taxable to the seller. Is this true? And if so, how do you solve that problem?
Thanks, Ryan

P.S. I may have misunderstood the person that told me this.

Comments(7)

  • TheShortSalePro23rd August, 2004

    Forgiven debt is viewed by the IRS as taxable income.

    If, in a short sale, the lender forgives $10,000 of the Seller's debt... the $10,000 is considered to be income.

    It is encumbant upon the Seller to prove to the IRS that the 'income' is exempt from tax.

  • I_Need_Help23rd August, 2004

    so how do they do that?

  • TheShortSalePro23rd August, 2004

    If you had an IRS problem... what would you do?

  • I_Need_Help23rd August, 2004

    explain to them that somebody else sold the house and that they already paid capital gain taxes?

  • TheShortSalePro23rd August, 2004

    perhaps you didn't understand my previous post in response to your question....the issue is not with capital gains tax... but with income tax....

    best to advise the Seller to see a tax professional... a CPA perhaps.

    Or, did I misunderstand your question?

  • I_Need_Help23rd August, 2004

    no i get what you are saying..thanks for your help..

  • JohnMichael23rd August, 2004

    The tax results of a foreclosure, deed in lieu of foreclosure, or short sale depend on the nature of the loan: whether it is recourse or non-recourse. Recourse means that the borrower has personal liability for the loan, in addition to the risk of losing his real property.

    Non-recourse loans include typical purchase loans used to buy an owner occupied residence of up to several units.

    Many state Law protects borrowers from personal liability on a purchase mortgage for a home which they occupy at purchase. (If the borrower later converts the home to rental, he is still protected.)

    Some cases allow the same protections for refinances IF there is no cash paid out to the borrower, or if any cash paid out is used for property repairs or improvements.

    If the loan falls within this statutory protection, it is a non-recourse loan. Other loans may be non-recourse by their terms.

    [Special rules may apply to VA and FHA loans.]

    The tax consequences of foreclosure, deed in lieu of foreclosure, or short sale on a non-recourse loan are simple: the property is taxed as if it were sold for the total outstanding amount of the loan (or sales price, if higher).

    Taxability of the gain and deductibility of the loss depend on the nature of the property.

    A recourse loan is a loan where the borrower is personally liable if the property is sold for less than the amount owed to the lender.

    There are two issues with a recourse loan: personal liability and taxation.
    Liability: Recourse Loan
    To obtain a personal judgment against the borrower, the lender must proceed with a Judicial Foreclosure. Even if the loan was recourse, if the lender proceeds with a Trustee's Sale, the borrower is relieved from personal liability for any remaining deficiency (which the lender cannot collect under a Trustee's Sale).
    Taxable Profit: Recourse Loan
    There are two elements of profit: `true profit,' and relief from debt income. `True profit' is computed as if the property were sold for its value; relief from debt income is taxable if the debt exceeds the property's value.
    A foreclosure, Deed in Lieu, or a short sale (involving recourse debt) are taxed identically.

    True profit' is taxed as if from a regular sale of the property and may qualify for a tax deferred sale of a primary residence (§1034) (if he plans on buying a new home within 2 years), and for the Over-55 Rule.

    The other kind of taxable income is `relief from debt income,' based on the difference between what is owed and the value of the property, $20,000 ($200,000 debt, less $180,000 value).

    The 2 year rollover (§1034) and the Over-55 Rules do NOT apply to relief from debt profit.

    Relief from debt income is taxable only to the extent that the debt relief results in solvency. If the owner has a negative net wealth before and after the sale, nothing is taxable. Alternatively, if he has negative net worth before, and $3,000 net worth after, up to $3,000 is taxable.

    If the owner is in bankruptcy, no relief from debt income is taxable.

    These rules are complicated and point out that in any circumstance in which unexpected tax results are possible

    In order for the delinquent interest, discount, or recovery of prior write-offs to be taxed as ordinary income, it must be shown that the property received was, in fact, worth at least as much as the principal of the mortgage note plus the interest, discount, or prior write-off. The mere fact that the borrower's liability for overdue interest has been discharged as part of the transaction will not in itself force the recognition of income to the lender. See Helvering v. Missouri State Life Insurance Co., 78 F.2d 778 (8th Cir. 1934). Conversely, the lender will realize a loss, which qualifies as a bad-debt deduction under §166 of the Internal Revenue Code, equal to the excess of the lender's basis in the debt over the fair-market value of the property transferred. However, if the borrower was an entity, as opposed to a natural person, the loss will be a capital loss, and the lender may want to reconsider whether to accept a deed in lieu of foreclosure as opposed to going through a foreclosure sale where any loss will be a bad debt decduction. See Bingham v. Commissioner, 105 F.2d 971 (2d Cir. 1939); Commissioner v. Spreckels, 120 F.2d 517 (9th Cir. 1941); Robinson, FEDERAL INCOME TAXATION OF REAL ESTATE, §10-07 (1984); I.T. 3548, 1942-1

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