It can be surprising to learn that after debts owed to a bank or individual are canceled, income taxes can still remain. This issue comes up frequently in connection with escaping distressed real estate. Following a foreclosure or short sale, it is not uncommon for a bank to issue a 1099 to the borrower and the IRS indicating the amount of debt canceled. The amount of debt cancelled may result in significant tax liability.
However, there are exceptions in the Tax Code that usually allow homeowners to avoid payment of debt cancellation taxes. The Mortgage Forgiveness Debt Relief Act of 2007, which applies to all 50 states, provides no tax on the short sale difference or foreclosure deficiency of a purchased money loan, or a loan used to improve the home, if it’s a primary residence.
This law is currently scheduled to sunset at the end of tax year 2012. This means if you are contemplating short selling a home you own, you may face severe tax consequences if that home is not sold by the end of 2012. As unfair as it may seem, a person selling or surrendering their home after January 1, 2013 may have to pay significant income tax when they would have had no tax exposure had they disposed of the home prior to the December 31, 2012.
If you are considering escaping an underwater property, there are already significant legal and practical incentives for doing a short sale rather than stopping payments and waiting for foreclosure. One additional reason for doing a short sale, now more than ever, is to ensure that the home is disposed of in the 2012 tax year. Awaiting foreclosure is likely to leave many in possession of their unwanted homes beyond the end of the year, potentially exposing them to tax liability.
Every person contemplating a short sale, foreclosure or strategic default should consult with a skilled, knowledgeable Arizona Real Estate attorney to discuss the possible consequences of escaping a distressed property. Additionally, short sales are not easy and require a high level of skill on the part of your realtor. Be sure to choose a realtor with significant experience with short sales.