Forced to do a Short Sale of Your Home?

In a letter to Senator Barbara Boxer, the IRS took the position that when a California homeowner sells the property through a "short sale" the mortgage will be treated as a non-recourse debt.

I know, you are wondering what that means, let alone if it is in English.

Let me try to break it down for you.

Under the Internal Revenue Code, when you owe someone money and that person forgives the debt, you are treated as having received income equal to the amount of forgiven debt.  This is known as "cancellation of indebtedness (COD) income".

Example:  Jill loans John $20.  A week later Jill tells John that he does not have to repay her the $20.  The IRS considers that $20 income to John because he would not have had it unless there was first a loan and then the loan was forgiven.

Why would a lender, like a bank, forgive your debt?  Typically, it is because the lender is convinced that you are unable to repay it.  In a housing situation, it may be because the house is "under water" and the bank has decided that it makes more financial sense to allow the homeowner to do a short sale (in which the bank approves a sale for less than the mortgage on the property, and forgives the debt on the excess mortgage) than risk having the homeowner stop making mortgage payments and be forced into a foreclosure.

For the past few years, Congress and California had an exception to the normal COD income rules.  The exception was that if the cancellation of indebtedness is for a mortgage on a person's principal residence, the COD income would be excluded from the person's taxes.  However, this exception expired in California on December 31, 2012, and it expired for the federal government on December 31, 2013.

The expiration of this exception was alarming to many.  It meant that not only would people be losing their homes, but they would have to pay the IRS and California significant amounts in taxes in order to lose their homes.  Senator Boxer reacted and sent the IRS a letter asking how it intended to treat California short sales.

The IRS responded (IRS Letter) that because under California law a lender cannot attempt to collect the excess mortgage from the seller in a short sale, the short sale effectively converts the mortgage into a non-recourse debt.

What does all this mean to you?

It means that, in California, a taxpayer who participates in a short sale does not have to recognize "cancellation of indebtedness" income.  The debt is forgiven and there are no adverse tax consequences as a result of the short sale.

California has indicated that they will follow the IRS's position on this issue.

Are you considering doing a short sale of your home?  If so, I would be happy to discuss this more with you.  Just send me an e-mail.

Also, I would be happy to refer you to a great realtor that specializes in short sales.

As always, please leave your feedback in the comments section below.

Update: The IRS has reversed its position and now does require taxpayers to recognize the cancellation of indebtedness income unless they fall into another exclusion.