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Cancellation of Debt: Short Sale vs Foreclosure

Many changes have taken place over the last few years.  Eight years ago, we became experts on 1031exchanges which allow you to defer paying taxes on gains when selling a property.  So many clients were selling real estate at a gain, we looked for ways to minimize, defer, or alleviate their tax burden resulting from these sales. However, the world is a changing place. 


One of our most common questions now is, ?What is the tax consequence of my house being foreclosed on / short sold?.  We have had so many clients with 1099-Cs issued to them over the last couple of years.  Again, we have become experts, but in a different area. 


First, if you are significantly upside down on your home, you are probably considering letting the property go back to the mortgage holder.  Are there tax consequences?  Absolutely, but we can help.


Between a short sale and a foreclosure, short sales are usually your best option.  This occurs when you can find a buyer for your home and the bank agrees to settle for less money than you owe.  Ultimately, the bank is short.  The bank cancels the debt and agrees not to pursue you or lay claim to your personal assets for the difference.  In case of foreclosure, there is no guarantee that the bank will not continue to pursue you and put liens against your other assets. 


Where do we come in, and how does this affect your tax bill at year-end? 


Cancelled debt is considered income for tax purposes.  If this home was your residence and you did not take cash out while you owned the property, then you may be able to exclude the cancelled debt from income using code section 108(a)(1)(E).  Even if you took cash out, but used that cash to improve the property, then this exclusion may also work for you.  However, the ability to exercise that exclusion as of now is set to expire at the end of 2013.   


Bankruptcy is another option which may allow you to exclude the income, but it should be filed prior to losing the property. 


In addition, some people find relief under the insolvency exclusion which means that at the time you lost the home, your liabilities exceeded your assets.  Insolvency involves a complicated calculation and should include your retirement accounts and the home that was relinquished along with the debt on that home.


We have become experts in the area of foreclosures, short sales, and cancellation of debt.  If you have questions in any of these areas, then let us help you. 


Rachel Santana, EA

Tax Accountant

Hamilton & Phillips PA