TAX IMPACT OF A SHORT SALE OR FORECLOSURE

There is a lot of confusion as to the treatment of a Short Sale or a Foreclosure.
We need to determine what a “short sale” is. A short sale is a sale approved by the lender where the proceeds received comes out “short” of the mortgage on the loan.
A foreclosure is a judicial process by which the lender takes over a property. Both actions may result in “debt forgiveness”.
Debt forgiveness is considered income by the Internal Revenue Code. Section 108. It is logical. If somebody loans you, say $50,000, and then you do not pay it for whatever reason, you are $50,000 richer!

In the context of buying a home it is viewed as follows:
You received a home that was valued at $700,000. You gave $50,000 down payment and owe $650,000. If you do not pay the $650,000 you received a $700,000 value for $50,000. That the house went down in value is not relevant, because the house could also have gone up in value. You owe the money; you don’t pay it, you have income.

The lender is going to send you a Form 1099-C Cancellation of Debt at the beginning of the year following the cancellation of debt.

It is up to you to report it in your income tax return and explain that it is not taxable to you, if there is an exclusion.
Do not ignore it!

When is the cancellation of debt excluded from taxable income?

First, we need to determine the type of real estate property, and in which state it is. In California, if the loan was used to purchase the real estate property, for a dwelling of not more than 4 families, and the purchaser occupied part of this property, all the lender can do is go after the property (foreclose). If there is a deficiency, the lender can not go after the debtor for the deficiency. Code of Civil Procedure Sect. 580b.
Since the debt is extinguished when the lender takes over the property, or the lender approves a short sale, there is no income!

The problem arises when the original debt has been refinanced.

If the debt was refinanced just to obtain better interest rates and the amount of debt and the lender remain the same, nothing really has changed. However, if the debt is paid off by another lender and now the new lender has the mortgage, this is not money that was used to purchase the property and the exclusion does not apply.
If you refinance and obtain an amount larger than the original loan, and you use the excess to improve the house, the debt is still viewed as made to purchase the house.
However, what has happened in the speculative economy is that people refinanced, or obtained a second loan, to buy other property or buy personal things. Under such situations, the exclusion does not apply.
This will determine whether the lender can come after you for a deficiency or whether the debt forgiven is taxable.
Your tax preparer must do a tracing of the funds obtained to determine what portion, if any, of the loan forgiven was excluded, and explain this when the IRS and the state returns are prepared. But do not ignore the Form 1099-C!

However, the first step is to determine whether the real estate was your residence or an investment, such as a rental.
If the property was your residence, then the federal government allows up to Two Million Dollars of forgiveness without taxing it. The state of California only allows you up to $250,000 on debt not exceeding $800,000.
If this is the case, you do not need to make an analysis of the use of loan funds.
But if the property is a rental, then the analysis is needed.
However, even if you do have debt forgiveness income, don’t forget that you have the rental deductions against that property. Chances are that if you had to give up the property you had losses; after all, you are losing some of your investment.
The message is: there is no quick way to determine if the debt forgiven by the lender is taxable to you. A detailed analysis of the loan is needed.
But whatever you do, do not ignore the 1099-C!

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