A federal income tax break that benefits people who sell their home in a so-called short sale is set to expire Dec. 31, potentially exposing these sellers to higher tax bills. Sellers have little control over the matter, though being financially insolvent might help, if Congress doesn't come to the rescue.
The tax break at issue is the ability to exclude certain mortgage debt forgiven by a lender from ordinary income. For example, if your mortgage balance was $150,000, you sold your home for $120,000 and the lender wrote off $30,000, you might owe income tax on that amount.
If you're surprised to learn that forgiven debt, sometimes referred to as "phantom income," can be taxable, you're not alone. In fact, few sellers are aware of this information, says Marian Norris, a Realtor with Prudential California Realty in Stockton, Calif., an epicenter of the housing crisis.
"They're shocked," she says. "They're already worried about displacement and where their children are going to go to school and how the sale will affect their credit, and now there's another layer of stress and distress added to the entire equation."
Slow short sales
Given the year-end deadline, your natural inclination might be to try to speed up your short sale.
But don't count on much, if any, support from your lender in that effort. Norris says lenders are so much aware of these distressing issues that they've effectively isolated themselves from borrowers, rather than deal with their concerns. Instead of a conversation with a live person, you're more likely to be confronted by paperwork, third-party contractors and websites, Norris explains.
"Most of the people aren't people," she says. "You're talking to a platform on the Internet or faxing information. They won't give you a direct-line phone number because they don't want or have enough people to speak to you."
Short sales are rarely fast, and Norris says sellers have no control over the timeline, which can extend for many months.
Date of forgiveness
What's more, a quicker sale might not solve your tax problem since the tax is triggered by the date when the mortgage lender forgives your debt, not when the sale closes, according to Mark Luscombe, principal federal tax analyst at CCH, a Wolters Kluwer tax software company in Riverwoods, Ill. The date of debt forgiveness might -- or might not -- coincide with the sale closing, depending on your lender's policies.
Either way, you should get some paperwork from the lender that spells out or references the date of the debt forgiveness. Luscombe says you needn't show that paperwork with your federal tax return, but you might have to produce it later if your return is audited.
If the tax break isn't extended -- and Luscombe says that could happen retroactively if Congress doesn't act before year-end -- you might be able to escape the tax by being financially insolvent. There's no hard and fast test of insolvency, except that you'll need to demonstrate that your liabilities exceed your assets.
"Some taxpayers going through [a short sale] may meet the definition of insolvency and be able to exclude forgiven debt on that basis, even if the mortgage debt [exclusion] doesn't survive," he says.
State tax codes
Another twist is that while many states have copied the federal tax code with respect to forgiven mortgage debt, others have imposed their own rules, according to Kathleen Thies, a state tax analyst at CCH. That means a short sale might -- or might not -- trigger state income tax, regardless of the federal tax.
"Not every state has adopted it exactly as the federal, but most states have embraced it to a certain extent," says Thies.
A good tip is to take a look at your state tax forms and instructions, which should be simpler than the tax code and might contain line items or other clues as to whether your state allows forgiven debt to be excluded from your income.
"Sometimes a state might not mention it because they're taking the federal adjusted gross income, so you don't need to make an adjustment on the state level (since) you already got that adjustment on the federal level," Thies explains.
The bottom line is that expert tax advice is strongly advised in connection with a short sale and the potential tax consequences of mortgage debt forgiveness.
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Marcie Geffner is an award-winning freelance reporter, writer, editor and blogger whose work has been published by MSNBC, CNBC, Yahoo! Finance, Fox Business, Bankrate.com, AOL Real Estate, ThirdAge.com, Fidelity.com, Inman News and dozens of major U.S. newspapers. She holds a bachelor's degree in English from UCLA and MBA from Pepperdine University. You can follow Marcie on Twitter: @marciegeff.