The tax break on short sales is due to expire on December 31, 2013.
Since 2007, Congress has waived the debt forgiveness tax when a homeowner does a short sale. This tax break was put in place at the beginning of the housing crisis and set to expire at the end of 2012. Congress extended it for one more year, to 2013. But the Washington Post reports it looks like it won’t be extended again.
Here’s the background. The basic tax rule is that debt forgiveness counts as income–and is taxed as income. If somebody cancels your debt–like in a short sale–you get a debt cancellation 1099-c. And you have to pay taxes on that “debt cancellation income.”
Cancellation of debt is “income.” And the income tax is a tax on income. So a short sale can lead to tax on that debt foregiveness income.
You can fight that. If you show the IRS that the lender never would have gotten the money anyway, then you defeat the tax. The IRS explains that here.
One way to show that is to file bankruptcy. Another way is to fill in this form. A third was is to live in a state where the lender can never come after you for a deficiency after a foreclosure. That’s the law in California, for example. But not here in Virginia.
Do you need to get out of a house where you owe way more than it’s worth? Most people who do would rather do a short sale than a bankruptcy. And if that’s your only problem, most bankruptcy lawyers would agree. Until now.
Now you have to worry about being hit for taxes on the amount of money the sale is “short.” If it’s a little bit, the tax won’t be much. But if you are short fifty or seventy five thousand dollars–and there are still homes around Northern Virginia that far underwater–the tax could be a big problem.
You should talk to a tax professional (not just listen to a real estate agent) about the tax consequences of doing a short sale. And if your tax adviser is not real confident you are ok under IRS Form 982, you should consider bankruptcy.
PS If you have a second mortgage, you also need to worry about whether the second mortgage is forgiving your deficiency–or are they just allowing to short sale to go through, but planning to sue you later. That happens a lot–I explain why here.