Tax Consequences of a Short-Sale or Short Refi

A concern of people that have elected to remedy their situation through a short-refi or short-sale is the tax implication on the forgiven debt. 

First and foremost, Mortgage Help Hotline is not a tax consultant.  We advise you as a homeowner to seek advice from a professional tax consultant or tax attorney for any questions concerning the tax on any forgiven debt as justified by the IRS.  You may read more about the Questions About Cancellation of Debt on the IRS website.

Is Cancellation of Debt income always taxable?

Not always. There are some exceptions. The most common situations when cancellation of debt income is not taxable involve:

• Bankruptcy: Debts discharged through bankruptcy are not considered taxable income.
• Insolvency: If you are insolvent when the debt is cancelled, some or all of the cancelled debt may not be taxable to you.You are insolvent when your total debts are more than the fair market value of your total assets. Insolvency can be fairly complex to determine and the assistance of a tax professional is recommended if you believe you qualify for this exception.
• Mortgage Forgiveness Debt Relief Act of 2007 - Amends the Internal Revenue Code to exclude from gross income amounts attributable to a discharge, prior to January 1, 2010, of indebtedness incurred to acquire a principal residence. Limits to $2 million the excludable amount of such indebtedness. Reduces the basis of a principal residence by the amount of discharged indebtedness excluded from gross income. Allows inclusions directly related to a decline in the value of the residence and to the financial condition of the taxpayer.

If you are not insolvent when your lender agrees to a short refi, let's look at the worst case scenario, you do not qualify for any type of tax relief and must pay the IRS on the forgiven debti.  Llet's say that your home was valued at $300,000 and you owe $300,000, which puts you at 100% LTV (loan to value), with no equity.  You then short-refi your home for $200,000, which puts your forgiven debt at $100,000.  It is the lender's prerogative to tax you on the forgiven amount.  Also, let's say that at the highest tax amount you will be forced to pay is at 28%, which means your tax on the forgiven amount amount to $28,000. 

If you short refinance, you will be given a 1099 from the lender the following year, which gives you time to get your finances in order and to start straightening out your credit.  When it comes time to pay the tax on the forgiven amount, the IRS will allow you to set up a payment plan.  The forms below will help ease or eliminate the tax implications on forgiven debt of a short-refi or short-sale.

By clicking on this link, you can see the form 982 and instructions.  This form is used by the IRS, to ease or eliminate the tax burden on the forgiven debt.  In most cases, to use this form, you must prove insolvency at the time of the action.  Please inform your tax professional of this form, to see if you fall within the guidelines of the form, to ease your tax burden.

H.R. 3648: Mortgage Forgiveness Debt Relief Act of 2007.  This law helps ease the burden of tax implications of a short-refi or short-sale.  By clicking this link, Mortgage Forgiveness Debt Relief Act of 2007 you will see more information on this new law.  As with the form 982, it has its set guidelines, but if you fall within the guidelines of this new law, it will also give you relief of tax implications from such situations.  Please inform your tax professional of this form, to see if you fall within the guidelines of the law, to ease your tax burden.

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e-mail: marie@affinity-financial.com