In short, if your short sale closes AFTER December 31st, 2012, you may owe taxes on the amount forgiven in the short sale.
If you have been studying up on the implications of a short sale, you probably know about two very important points:
- When you settle a debt, the difference could be your responsibility.
- When you settle a debt, the difference could become taxable income.
Currently, when you short sale your home, the amount that the bank writes off as a loss (the amount you were upside down) is reported to the IRS as debt cancellation, which appears as income on your personal finances, and as long as you meet the requirements (see your tax advisor) you will be able to offset that income and avoid income taxes on it.
That is about to change, unless the powers that be vote to extend the act which expires at the end of 2012.
The Mortgage Debt Relief Act of 2007 generally allows taxpayers to exclude income from the discharge of debt on their principal residence.
Let’s say you earn $45,000/year and you live in a house worth $100,000 that has a mortgage of $200,000. You find that your monthly expenses are excessive and you cannot afford to stay, so you short sell your home. When the house closes escrow, your lender receives a wire for about $90,000 (closing costs) and you have debt forgiveness in the amount of $110,000, give or take.
Suddenly you find yourself in a tax bracket based on $155,000 income for that year!?! ($45,000 + $110,000).
If this forgiveness is taxable, you may find yourself in debt to the IRS to the tune of $40,000 or so.
So, here’s the basic barometer.
IF YOU ANTICIPATE THAT YOU’LL NEED TO MOVE BEFORE YOUR HOUSE IS WORTH MORE THAN YOU OWE, YOU CANNOT AFFORD TO WAIT TO SELL YOUR HOME.