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Taxes Implications of Selling, Foreclosures and Short Sales

There is no free lunch with the IRS. If you transfer title on your home, whether voluntarily through a grant deed or warrantee deed or involuntarily through foreclosure, you have sold your home. You might be subject to taxes, even if you sold your home at a loss, either through a short sale or by foreclosure.

It doesn't seem fair. What's worse is you might not even find out that you owe taxes until the day you open your mail to find a 1099.

Gains and Losses

Sellers who have owned their personal residences for lengthy periods still will realize gains when a sale occurs.

Sellers of residences acquired within the past two years or so or cashed out their equity are going to incur losses. Even assuming no price declines, losses will result because of transactional expenses. Sellers will not be able to deduct those losses. In IRSís eyes it makes no difference that the seller is forced to sell because of, job changes or health reasons.

Besides problems for sellers of personal residences, there are tax troubles for investors who, say, bought several condos in places like the Inland Empire and are unable to flip them because prospective buyers are waiting for further price declines. Often, it is not worthwhile for those investors to rent their places; what they receive as rent payments will be insufficient to cover their real estate taxes and mortgage interest. Their only option is to sell at a loss."

Offsetting Losses Against Gains

One can offset their capital losses against capital gains. But in the absence of capital gains, the yearly cap is $3,000 ($1,500 for married couples filing separately) on the amount of losses they can offset against their "ordinary income," meaning income from sources like salaries, pensions and withdrawals from retirement plans. The law allows them to carry forward unused losses to later years.

Tax Rules for Foreclosures

The IRS has tax rules for foreclosures or repossessions by lenders of homes of owners who have fallen behind on their mortgage payments. There can be severe and unexpected tax consequences for an owner who simply walks away because he or she has little or no equity and the lender takes over and sells the place.

In this situation, cancellation or forgiveness by the lender of the debt usually means the debtor has reportable income, though there are some exceptions -- for instance, insolvency.

Personal Liability

Example: John buys a home and uses it as a personal residence. He pays $300,000, down payment of $15,000 and takes a mortgage loan of $285,000. He is personally liable for the mortgage. When the remaining balance of the loan is $280,000, John defaults and the lender bank accepts his voluntary conveyance of the home, canceling the loan. Similar homes at that time sell for $230,000.

The tax code treats the transaction as a sale. John incurs a nondeductible loss of $70,000, the amount by which his home's adjusted basis of $300,000 exceeds its market value of $230,000. No deduction for the loss because John uses the home as a personal residence.

John also has reportable income of $50,000 when the bank cancels the loan. The $50,000 is the amount by which the debt of $280,000 exceeds market value of $230,000.

Here comes the IRS, when the mortgaged property is foreclosed or repossessed, and the bank reacquires it, or the bank knows John has abandoned the property. The bank sends a Form 1099-A to John and the IRS. Using the numbers in the example, the 1099-A indicates the foreclosure bid price ($230,000), the amount of Johnís debt ($280,000), and whether he was personally liable. Debt cancellation (here, $50,000) is taxed at the rates for ordinary income, same as for salary.

Secured Debt Without Personal Liability

The IRS says sellers who are not personally liable for a debt will realize an amount that includes the full canceled debt, even if the value of the property that is security for the debt is less, which can be offset depending on your adjusted basis in the property. Purchase money loans secured by real property in California carry no personal liability.

Example, Mary buys a home valued at $300,000, puts down $30,000 and takes out a mortgage of $270,000. Mary stops making payments. The bank forecloses on a loan balance of $260,000, and the market value of the home has fallen to $250,000. Mary has an adjusted basis of $265,000, due to a $5,000 casualty loss. The amount Mary realizes on the foreclosure is $260,000. Mary figures her gain or loss by comparing $260,000, which is the amount realized, to her adjusted basis of $265,000. She has a $5,000 realized gain.

Plan Ahead Before Selling or a Foreclosure

Before you sell on a short sale or go through a foreclosure, seek legal and tax advice. Do tax planning ahead of time, before it is too late.

For more information, contact a Certified Public Accountant or check the IRS Web site.

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