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How Will a Short Sale Affect my Taxes?

If you need to sell your home for any reason and you are like most of San Diego’s 30% of “underwater” homeowners who owe more on their homes than they are worth, then a short sale is most likely your best solution.  Understanding the tax implications that a short sale will have on you will be important to making the decision.

Since the introduction of the 16th Amendment in 1913, Americans have inevitably filed and paid their Federal and State taxes.  Of course, the sale of real estate has it’s inclusion in those tax codes.  So, how does the short sale of your San Diego real estate apply within the Federal and State tax codes?  And more importantly, how does a short sale affect the Federal and State taxes that you will typically pay on the sale of your real estate?

Federal Taxes on Short Sales in San Diego.

Mortgage Debt Relief Act of 2007 –

When a taxpayer receives proceeds from a new loan, those proceeds are not taxable income because there is an offsetting obligation to repay the debt.  In order for one to sell their home when they owe more than the home is worth, the lender(s) of the debt must agree to cancel or forgive a portion of the debt to allow the sale to occur.  That difference is considered canceled or discharged debt.  If that debt, or any portion of it, is in fact canceled, that such difference is considered taxable income. This basically means that if you owed $300,000 and short sold the home for $250,000, your next tax return would reflect an additional $50,000 of earned income and would be treated as taxable income.  Is that where it stops?  Nope, not since the Mortgage Debt Relief Act of 2007.

Federal taxes on mortgage debt forgiveness are covered under the Mortgage Relief Act of 2007, but this Act is set to expire December 31st of 2013.  This bill eliminates tax on up to $2 million of debt for a principal residence. This bill protects primary residence homeowners only (not investors), and the best part about this bill is that it is retroactive to January 1st, 2007. This means that any California short sale conducted after that date is protected from Federal tax implications.

Other Exclusions –

Since the current exclusion is set to expire on December 31st, 2013, and if it does in fact expire, then you must rely on other debt forgiveness income exclusions such as insolvency or bankruptcy.

In such situations where you are not protected under the Mortgage Relief Act of 2007, or if/when the Act expires, you will receive a 1099-C from the lender forgiving the debt.  Like any other 1099, you must report the amount in Box 2 of the 1099-C to the IRS.  Yes, you must report the forgiven/canceled debt as income to the IRS even though you did not actually receive any money (also known as phantom income).  However, the IRS recognizes insolvency as a situation where canceled debt might not have to be reported as income.  You are insolvent when your total debts are more than the fair market value of your total assets.

If you are indeed insolvent, you are able to explain this to the IRS with one of two options. (1.) IRS Form 982: Reduction of Tax Attributes Due to Discharge of Indebtedness, or (2.) Attaching a detailed letter to your tax return that includes itemization of your total debts and total assets, showing that the balance of your debts exceeds that of assets.

Bankruptcy also allows for excluding this forgiven debt as taxable income.  According to IRS Publication 4681, “Debt canceled in a title 11 bankruptcy case is not included in your income. A title 11 bankruptcy case is a case under title 11 of the United States Code (including all chapters in title 11 such as chapters 7, 11, and 13), but only if the debtor is under the jurisdiction of the court and the cancellation of the debt is granted by the court or occurs as a result of a plan approved by the court.”  This type of exclusion also requires the use of either IRS Form 982.

IRS Circular 230 Disclosure.  To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this document is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing, or recommending to another party any transaction or matter that is contained in this document.

CA State Taxes on Short Sales in San Diego.

As we all know, in addition to paying Federal taxes, we are also required to pay our California State taxes.  So, with the use of the same examples above, let’s say that you owed $300,000 on your San Diego property but short sold your property for $250,000.  In such case, you would receive a 1099-C for the amount of the canceled or forgiven debt, which would ordinarily require you to report such to your state, and ultimately require you to pay applicable state taxes on that amount.  Fortunately for San Diego sellers of short sale real estate, the State of California provides a similar bill as the Federal government’s as discussed above.

Senate Bill 401 Conformity Act of 2010 –

On April 12, 2010, the State of California introduced the Senate Bill 401, the Conformity Act of 2010, into applicable law.  The SB 401 is a California law that essentially adapts the Federal government’s Mortgage Debt Relief Act of 2007, with a few modifications.  The SB 401 allows an exclusion of any debt relief or debt cancellation from being applied to the gross income reported to the State of California.  Wherein the Federal provision applies to debt cancellations occurring in 2007 to 2012 and with limitations of $2,000,000 (limited to $1,000,000 in single taxpayers), the State of California provision applies the following modifications:

  • For taxable years 2009-2012, limits the amount of qualified principal indebtedness to $800,000 for married filing jointly, single, head of household or widow/widower, and further limits the same to $400,000 for taxpayers who filed as married filing separately.
  • For taxable years 2009-2012, limits the total debt relief exclusion to $500,000 for for married filing jointly, single, head of household or widow/widower, and limits total debt relief exclusion the same to $250,000 for taxpayers who filed as married filing separately.
  • For taxable years 2007-2008, limits the total debt relief exclusion to $250,000 for for married filing jointly, single, head of household or widow/widower, and limits total debt relief exclusion the same to $125,000 for taxpayers who filed as married filing separately.

To file for your debt relief provided under SB 401 in the state of California:  Upon filing your tax return with the State of California (form 540 tax return), and assuming that your debt relief does not exceed the California limit(s), include a copy of your Federal tax return and the Form 982, which is discussed above.  The state of California does not provide any state-specific debt relief form as the federal agency does.

We are not tax experts or qualified to advise on tax codes.  Information on this page is provided for informational purposes only.  We advise you confirm the information provided herein with a tax professional.  We advise you consult with a tax professional before considering a short sale or any other voluntary or involuntary transfer of real estate.

In our opinion, the best way to make a prudent decision is to educate yourself. Keep reading…

Contact us for help in understanding and establishing your best solution with your San Diego real estate property.

The information contained herein has been provided by San Diego Board of REALTORS®. This information is from sources deemed reliable but not guaranteed by San Diego Board of REALTORS®. The information is for consumers' personal, non-commerical use, and may not be used for any purpose other than identifying properties which consumers may be interested in purchasing.

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