Tax Implications of a Short Sale or Foreclosure
The last thing you want to deal with when facing a foreclosure or short sale of your principal residence is worrying about the tax ramifications; however, they can be very significant and they should be part of your analysis. There are two major tax repercussions in dealing with a short sale or a foreclosure. First, the sale (deemed or actual) of the property may trigger a taxable gain and second, the cancellation of debt (COD) income.
First, to determine if you have a taxable gain related to a short sale or foreclosure you need to determine the amount realized (sale price) and your basis in the property. The amount realized for a short sale is the sales price of the residence less any selling costs. For a foreclosure the sales price is the fair market value of the property. Generally, your basis in the property is the purchase price plus remodeling and other capital expenditures. The difference between the amount realized and the basis of the property is your realized gain or loss. If you have a gain the gain can be excluded if you meet the requirements under IRC Section 121. Any portion of the gain that is not excluded will be a capital gain and if the property has been held for more than one year it will be a long-term capital gain.
Second, when a debt is cancelled it triggers cancellation of debt income which is taxable to you unless it can be excluded under special exception. The COD income for a short sale will be the proceeds of the sale less the debt balance. For a foreclosure the COD income will be the difference between the fair market value of the property less the debt basis. The COD income is reported to you on Form 1099-C or 1099-A. In the case of a short sale the COD income will be the difference between the debt you owe less the sale price of the home. With a foreclosure, the COD income will be the difference between the debt and the fair market value of the home at the time of foreclosure. The two most common exclusions of COD income are qualified principal residence indebtedness and insolvency. Up to $2 million of COD income can be excluded under the qualified principal residence exclusion as passed under The Mortgage Forgiveness Debt Relief Act and Debt Cancellation. The current exclusion is set to expire in 2012 and if it does expire then you must rely on other COD income exclusions such as insolvency or bankruptcy. To qualify for the insolvency exclusion you must attach a statement to your tax return that shows your total assets and total liabilities and if the liabilities exceed the assets by more than the COD income then you can exclude the entire COD income from your taxable income.
If you are going through a short sale or foreclosure there are many tax implications to consider and you should ensure that you engage a tax professional to help you navigate the complexities. Please contact us for a free consultation.
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