Short Sale and Foreclosure Consequences
There is a tremendous amount of confusion regarding what the financial consequences of a short sale are for a seller. The major difference is that a foreclosure is a credit item that lasts forever. A short sale is not.
Beyond that there is a need to understand the financial consequences of a short sale.
Mortgage Forgiveness Debt Relief Act of 2007
This act was originally introduced as HR 3648 and was passed into law on December 20th 2007 when it was signed by the president. The Bill received an overwhelming amount of support in the House and was seen by many as a major step in the right direction.
Prior to the passage of this law, for any debt that was forgiven in a short sale or a foreclosure, the homeowner would receive a 1099 and would have to report this forgiven (or cancelled) debt as income. This still holds true for those individuals who do not qualify for the exceptions of this act.
From January 1, 2007 to January 1, 2010, "this law" eliminates the phantom tax on debt cancellation in mortgage discharge.
- Debt must have been debt incurred to acquire a principal residence.
- Cancelled debt up to $2,000,000 is eligible.
- Sets forth rules for determining the allowable amount of the exclusion for taxpayers with non-qualifying indebtedness and taxpayers who are insolvent.
- Debt from a second (non acquisition) mortgage or HELOC is not eligible.
- Cancelled debt from investment properties and second homes is not eligible.
This law extends through 2010. The tax deduction for mortgage insurance premiums, previously was only in place for 2007. One in ten homeowners pay PMI. This will save the average homeowner with PMI approximately $350 per year
This law allows deduction of payments to a co-op corporation if:
- 80% or more of the total square footage of the corporation's property is used or available for use by its tenant-stockholders For residential purposes
- or 90% of the corporation's expenditures are for the acquisition, construction, management, maintenance, or care of its property for the benefit of the tenant-stockholders.
- For homeowners with income under $100,000 a year making up to $109,000 a percentage is deductable. For over $109,000 there is no deduction.
This law reduces the income tax breaks on most gains from the sales of non-primary residences using a formula based on the amount of time that the taxpayer actually lived in the property during the five-year period before the sale. Previously a homeowner only had to have lived in property for 2 years to have non-taxable income of $500,000 after 5 Years.
This law allows a surviving spouse to exclude from gross income up to $500,000 of the gain from the sale or exchange of a principal residence owned jointly with a deceased spouse,
- If the sale or exchange occurs within two years of the death of the spouse (previously was only one year) and
- The property was used as a primary residence for at least 2 of the previous 5 years.
And this law allows members of a qualified volunteer emergency response organization (i.e., an organization that provides firefighting and emergency medical services) an exclusion from gross income for stare and local tax benefits and for certain payments for services. It terminates such exclusion after 2010.
It allows certain full-time students who are single parents and their children to live in housing units eligible for the low-income housing tax credit provided that their children are nor dependents of another individual (other than a parent of such children).
It increases the penalty for failure to file a partnership tax return and extends from 5 to 12 the number of months in which such penalty may be imposed. Limits disclosure of tax return information that includes individual taxpayer identify information.
It imposes an additional penalty on S corporations for failure to file required tax returns. It amends the Tax-Increase Prevention and Reconciliation Act of 2005 to increase to increase the estimated tax payment due in the third quarter of 2012 for corporations with assets of at least $1 Billion.
Possible Tax Consequences
There may be tax consequences, if your borrower does not qualify for the above exclusions.- The IRS defines the amount your borrower is "short" as having been "cancelled." It is also required for the lender that allows this debt cancellation to issue your seller a 1099 for this amount and your seller is required to claim this amount as income.
If a property is foreclosed on, this is also debt cancellation and the default amount can also be treated the same way. In most cases the amount of default with a foreclosure will be much greater than with a short sale, so your client will be better off for many reasons by avoiding foreclosure.
According to the special section of the IRS website entitled "Questions and Answers on Horne Foreclosure and Debt Cancellation" cancellation of debt income is not always taxable
The IRS provides the following calculation:
Step 1 - Figuring Cancellation of Debt Income
(Note: For non-recourse loans, skip this section. You have no income from cancellation of debt.)
1.
Enter the total amount of the debt immediately prior to the foreclosure___________
2. Enter the fair marker value of
the property from Form 1099-C, box 7____________
3. Subtract line 2 from line 1. If
less than zero, enter zero._______________________
The amount on line 3 will generally equal the amount shown in box 2 of Form 1099-C. This amount is taxable unless you meet one of the exceptions in question 2. Enter it on line 21, Other Income, of your Form 1040.
Step 2 - Figuring Gain from Foreclosure
4. Enter the fair market value of
the property foreclosed. For non-recourse loans, enter the amount of the debt immediately
prior to the foreclosure_______________________
5. Enter your adjusted basis in the property. (Usually your purchase
price plus the cost of any major improvements.)_______________________________________________
6. Subtract line 5 from line 4.
If less than zero, enter zero._________________________
The amount on line 6 is your gain from the foreclosure of your home.
If you have owned and used the home as your principal residence for periods totaling at least two years during the five year period ending on the date of the foreclosure you may exclude up to $250,000 (up to $500,000 for married couples filing a joint return) from income. If you do not qualify for this exclusion, or your gain exceeds $250,000 ($500,000 for married couples filing a joint return), report the taxable amount on Schedule D, Capital Gains and Losses. (1)
Not very simple after all, right? The bottom line is that when it comes to accounting and tax issues (unless you are an accountant), you should refer your to a qualified accountant. The reality of this situation is that if a person is truly insolvent and their debts are higher than their assets, there is a good chance they will not have to pay tax on the cancelled (short) amount if they report their taxes correctly.
Future Financial Consequences
Your credit score will go down about a minimum of 50 to a maximum of 350 points or more. A reduction as little as 50 points is rare. Typically, the reductions are from 100 to 250 points. The range depends primarily on their initial credit score, credit history and how many other items on your report that you aren't paying. The only items that show up on your credit report are the missed payments from a short sale. Anything else will drop off your credit report after seven years. If you are diligent you can rebuild your score in as little as 18 months but usually it takes around 2 years.
Deficiency Judgment
(Does not apply in California, Minnesota, Mississippi, Montana, North Dakota and West Virginia)
In rare cases lenders also pursue a deficiency judgment against borrowers and attempt to collect the amount that was short. This does require a separate action to be filed in court causing the mortgage company to incur further expense. 'The mortgage company is also acutely aware of the borrower's inability to pay they see further collection as fruitless. It is also important to recognize that a short sale should get the lender more money than a foreclosure. Where the bank has a right to pursue a deficiency judgment in a short sale, they also have the same right in a foreclosure. When considering all consequences a short sale is almost always' better than a it is also better for your credit history.