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Foreclosure And Short Sale Tax Falacies
Posted by on Sunday, February 5, 2006 at 1:44 PM (PST)
You may have heard commercials telling you that if you lose your home in foreclosure or sell it through a short sale, you can be liable for a substantial amount of income tax on the amount you save through "debt relief." Whichever company is putting out the commercial also claims that they can help you avoid these income taxes when you want to get out from under your house payments.
Companies that make these offers usually promote their services by a free video they will send you (although more recently some of them are also offering a commission to financial counselors for referrals.) They explain that if your property is no longer worth the amount of the loan against it, you have two choices: you can negotiate a short sale (a short sale occurs when the lender releases its collateral interest for less than your indebtedness to accommodate a sale of the property to a third-party buyer), or you can allow the property to go into foreclosure. Either way they predict dire tax consequences.
The companies' plan provides for you to deed your property over to them and pay them a small percentage of your
original loan balance. Thus, they negotiate the short sale or allow the foreclosure. The 1099 form (the form used to report this and certain other kinds of income) for the amount of debt relief that represents taxable income, will be issued to them, not you.
The Better Business Bureau cautions homeowners against accepting at face value the representations of companies offering plans such as this. First, these companies imply that whenever your property is worth less than what you owe on it, you will owe tax on the debt relief that results from either a short sale or a foreclosure.
The fact is that you may owe tax, or you may not, depending upon the circumstances. Furthermore, if you do, the amount on which you are liable is not calculated according to the methods they present.
The formula for calculating tax liability is important, so let's talk about that first. These companies tell you that, in the case of a short sale, your tax liability is figured on the difference between the fair market value of your house and what you owe on it. In the case of a foreclosure, they tell you that your tax liability is calculated on the difference between what you owe on the house and the amount it is sold for after foreclosure.
However, neither fair market value nor later selling price enters into the calculation. Tax liability is actually calculated on the difference between the purchase price or tax basis of your home and the amount you owe on it at the time of the short sale or foreclosure. ("Tax basis" is the purchase price plus improvements you may have made to your home, less depreciation and any deferred gain on the sale of any previous home.)
Therefore, if you owe less than you paid, regardless of present value, you may not owe tax at all.
But in general, if you owe more than your tax basis, you will owe taxes after a foreclosure or short sale. For example, suppose that after you bought your first home, you sold it at a gain of $150,000. You then rolled over that gain into your second home, which had a purchase price of $400,000 and a mortgage of $300,000. Because of this rollover, your tax basis is $250,000 ($400,000-$150,000), rather than the amount of the purchase price. A foreclosure by the lender constitutes a sale at the price of the current amount due on the loan, $300,000. The difference on which taxes would be due, then, is $50,000.
Another example would be where your home's value appreciates and you refinance. Say you buy the house for $300,000 and now owe $275,000 on the mortgage. You refinance for $350,000. You now owe $350,000, but you have $75,000 in cash from the refinancing. In the event of foreclosure, you would also owe taxes on the whatever you realized from refinancing but have not yet repaid.
A similar result would occur if you took out a second mortgage or a home equity line of credit and later lost your home in foreclosure without having repaid the balance due on the new obligation.
The representations that these companies, rather than you, will become liable for taxes if you deed your property to them is not true. First, the Internal Revenue Service cautions that deeding your property to one of these companies does not constitute a bona fide sale. Rather, the IRS views the company as an agent, working for a fee, to help sell the property. And even if the IRS accepted it as a bona fide sale, the transfer of the property would constitute, for income tax purposes, a sale by you to the company, resulting in tax liability to you, not to the company as the buyer. Furthermore, if you underpay your income tax because of this plan, the IRS says you will be liable for the tax deficiency plus interest and penalties.
The company may not receive the 1099 form after you deed your property to them because federal regulations do not require issuance of 1099s to corporations. But unless the mortgage holder is willing to consent, in writing, to the new company's assumption of the loan, you will receive the 1099, whether you have signed your property away or not. Moreover, the fact that you may not receive a 1099 has nothing to do with eliminating your tax liability. (You would be responsible for income taxes if, for some reason, you did not receive a W-2 form reporting your wage or salary earnings, wouldn't you?)
Besides unexpected tax consequences, your credit report can suffer whether your property goes into foreclosure or whether you try to avoid foreclosure by deeding it over to one of these companies.
First, if the lender doesn't agree to the assumption of your loan by whomever you've deeded your property to, the lender will not regard the transfer as a bona fide sale but will simply continue to look to you for repayment of the debt. It follows, then, that negative credit information, such as late payments or a foreclosure, received by a credit reporting agency from the lender, will become part of your credit record, not that of the company that acquired the property. And remember that the company you deed your property to forewarns you that they are not going to make payments on it.
The "legally-permitted strategies" some companies claim they use to lessen or eliminate "potential future effects" appears to be only, in the case of a foreclosure on your credit record that results in your being denied credit, to provide a letter for you to submit to the credit reporting agency, along with a copy of the deed recorded to transfer title, to explain that at the time of foreclosure, you did not own the property.
Whatever their claims, it is not likely that your credit report will remain free of the adverse information.
Nevertheless, more recently, some of these companies have been offering credit repair services. In case their
original claims of protection against negative credit report information don't give you the assurance you want, you can make doubly sure no negative information will appear on your credit record by taking advantage of this service.
Upfront fees charged by companies like these are in the area of $100 to $150. If you decide to use their services--that is, to deed your property to them-- they will allow this amount as credit against their fee, which is 1 percent of the
original amount of the loans against your property. If you want to use their credit repair service, you will have to pay an additional charge of up to to several hundred dollars.
The Better Business Bureau reminds you that no one can cause accurate negative information to be removed from your credit report before the time allowed by law has expired. (In most cases, this is seven years.)
Thus, in spite of claims to protect you from taxes for which you may not be liable in the first place, you may give up your property--and pay a hefty fee to do it--only to retain the tax liability you thought you were averting and to risk damage to your credit
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The information contained in this website is intended to be used for informational purposes only and to provide a general overview of the topics described herein. There may be tax and other legal consequences associated with a short sale. I SHORT SALE makes no representations or warranties concerning potential tax or legal consequences relating to any final disposition of any property. Clients are advised to consult with a tax professional regarding the potential tax consequences for their particular situation. I SHORT SALE is providing a service in response to a complex situation and offers a recommended solution where possible. Nothing is represented as tax advise to our clients as every situation may result in different tax consequences. I SHORT SALE is not a law firm or an accounting firm and regarding any specific questions relative to any transaction, I SHORT SALE strongly encourages all parties, agents, and brokers involved in a transaction to seek such advice from a professional advisor. Legal Statement
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