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Will the forgiven money on a short sale be reported to the IRS as income?

One of the most common concerns that sellers have when we discuss working with them to do a short sale on their home is:

Will I be taxed on my the forgiven debt from my Ohio short sale? Call Andy with more questions or to get your home sold on a short sale. 216-324-6637

“Can we negotiate with my lender to not send a 1099 for the forgiven deficiency left over from the closed short sale?”

The answer is you can absolutely try however it is futile effort because many things are negotiable but if your lender forgives that deficiency by law they have to report it to the IRS as earned income.  However for most of my clients this is not an issue because there are several possibilities for canceling or offsetting that phantom income.

1) Mortgage Debt Foregiveness Act of 2007 (see IRS website on this)- If your home was a primary residence for 2 out of the last 5 years and you had do a short sale a married couple can exclude up to 2 million dollars of phantom 1099 income caused by forgiving the deficiency on such debt.

2) Bankruptcy- According to IRS publication 4681, any debt canceled under a chapter 7, chapter 11 or chapter 13 bankruptcy will not be taxable.

3) Insolvency- If your total assets (including retirement accounts, mortgaged real estate, property with liens on it etc) is less than your total debt then you are considered insolvent.  Page six of IRS publication 4681 includes a worksheet that makes determining whether you were insolvent easy.  If you are determined to be insolvent at the time immediately before your canceled debt you can exclude the amount of canceled debt by an amount up to what you were insolvent by before your debt was canceled.  So if after you short sale your home there is a $100,000 in deficiency and you have $3,000 in your bank account and a $10,000 paid off car, no other assets and no other debt and then your bank forgives the $100,000 in debt you would be liable to pay taxes on only $13,000 of that forgiven debt.  If instead you had no other assets and 5,000 in credit card debt you would not be liable for taxes on any of the $100,000 in phantom income.

4) Offset income by your personal loss on the sale –  If your tax basis is $350,000 and your house sells on a short sale for $250,000 then you have a $100,000 loss.  If your forgiven phantom income is $120,000 then if you can’t get out of it via the Mortgage Debt Forgiveness Act of 2007, Bankruptcy or Insolvency you will only be on the hook for the $20,000 difference between your loss and the phantom income.

5) Gift- If a creditors cancellation of debt comes as a gift (see IRS definition of gift) to the debtor you don’t have to consider it income.  Theoretically you could negotiate that the debtor put in their acceptance letter that all forgiven debt is a gift to the debtor.  I don’t know that the IRS will buy this but I didn’t see anything in the IRS definition of gift or in the Publication 4681 that would specifically disallow this.  It is certainly worth a try if all other options for not paying taxes on the forgiven debt have been exhausted.

6) Non recourse- If  you didn’t sign personally on a mortgage debt that is attached to a property you own then debt forgiven on that property won’t be taxable to you.  This will not be the case for most people as these types of loans usually are used to finance large commercial properties or occasionally private / hard money renovation projects.

Form 982 (download it here) is the form you file with the IRS along with your tax return to note any exclusion on phantom income from forgiven debt.

I hope this helps.  Feel free to ask me more questions on this topic or any other Ohio Foreclosure Short Sale related topic.

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Andy Morris is an Ohio real estate broker with an expertise in selling homes on a short sale. If your Ohio home is heading towards foreclosure or you owe more than your property is worth, please call Andy at 888-4-STOP-IT to see if you qualify for a short sale with your lender.  Are you not in my area?  His foreclosure answer service is free to you as well

disclaimer- I am not an attorney and I am not an accountant.  Any information here might be erroneous. Please depend only on a qualified specialist advisor to make your decisions.

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