For BOTH Homeowners AND Investors

There is a very common misconception out there about the tax consequences after foreclosure.  It goes something like this: tax liabilities are inevitable for a property owner (either a Homeowner or an Investor) and that if a property goes through foreclosure, there may be less potential tax consequences to deal with as opposed to the property being sold through a Short Sale.  This misconception is causing many property owners to make decisions (for instance – not proceeding with a Short Sale that actually would be in their best interest) that could literally cost them thousands of dollars or throw them into bankruptcy.  While there is no question that any type of debt forgiveness can trigger a 1099, the 1099 after a Short Sale and the 1099 after a foreclosure can be handled in such ways as to effectively minimize the actual tax paid on the debt cancellation amount and in many cases handled correctly there will be no tax payments necessary.

I will first start off by saying that I am not a tax attorney or an accountant.  So for a complete understanding of the following concepts, I would recommend seeking professional advice.  What I am writing is based upon my reading, understanding and discussion of the legislation and of the IRS publications that are commonly available.  I will include links to those documents for those of you that are interested in understanding this topic better.

In the early part of the foreclosure crisis, Congress enacted legislation called ‘The Mortgage Debt Relief Act of 2007’ (http://budurl.com/37yh).  The main part of this legislation was directed at the primary residence homeowner.  Following this legislation, it became widely believed that only the primary residence homeowner received tax relief from a 1099 received after foreclosure or after Short Sale.  What this misconception overlooked is that the tax liability following the receipt of a 1099 could still be effectively reduced by other provisions in the tax code that deal with issues of insolvency.  Many Investors felt dismay and became quite forlorn when they felt that their underwater single family house purchases were ‘going down’ and dragging them with them.  Not only that, when all was said and done they feared that they would be hit with big 1099’s and resulting big Income Tax payments in the following years that would throw them into bankruptcy.  Why wouldn’t they?  After all many of these small portfolio investors were usually good people who never missed a payment on anything in their life and had no prior reason to consider or understand anything about the meaning of insolvency.

So what is insolvency?  It is very simple.  One is insolvent when the amount that they own (their assets) is less than the amount that they owe on what they own (their liabilities.).  In the type of insolvency that is important on property debt forgiveness, the amount of insolvency that is present on the date that the debt is forgiven is critical in determining how much potential tax would be due the following tax day.  This concept is discussed in detail in IRS publication 4681 (http://budurl.com/ees7). 

What seems to have been overlooked in the dramatic ‘Mortgage Debt Relief Act of 2007’ legislation passed in December is that there was then and still remains today a very good vehicle for property owners who face substantial debt cancellation following a Short Sale or Mortgage Foreclosure to avoid unnecessary taxes on the debt forgiveness that gets passed on to them by the lender.

What does this mean for the average person?  Well, if you are a homeowner who lives in the property that is late on payment or facing foreclosure you have two avenues that may benefit you when you have to endure the loss of your home.  You can use the special provisions outlined under the Debt Relief Act and you can also consider using the special tax treatment provisions outlined under the insolvency guidelines.  While Investors (those who do not live in the property facing mortgage foreclosure) who thought that they would be hammered by the tax bill after a Short Sale or Foreclosure, actually do have a very powerful tool to avoid tax payments as a result of the debt cancellation.  They can use the provisions under the definition of insolvency, if they apply, to minimize any potential tax impact arising out of the Short Sale or the foreclosure sale.

The bottom line on all of this is that Congress saw a number of homeowners who were facing foreclosure – an obvious political opportunity.  In order to save them from complete financial ruin, legislators added the ‘Qualified Principal Residence Exclusion (QPRE)’.  This additional provision allowed homeowners to avoid tax liability in cases of Foreclosure or Short Sale WITHOUT having to wipe out their financial holdings, to become insolvent, or to have to go through bankruptcy.  The implication of this is that despite the financial upheaval of losing their home,  the homeowner did not have to become financially devastated as well.  On the other hand, while the Investor does not have the financial ‘life preserver’  of the ‘QPRE’ available to them, it has been my experience that most of Investors that have distressed properties in their portfolio are insolvent as well – or very close to it – at the time of the Short Sale or the Foreclosure so as to be able to take advantage of the insolvency exclusion in the next tax filing period.

One other thing that is interesting in regards to this concept.  I was recently listening to a discussion of this issue by a Leading Real Estate Attorney and Real Estate Investor, Jeff Watson (http://budurl.com/dy6z).  He made a couple of very important points that I think need repeating.  First he said, the number one rule of dealing with property in a negative equity situation (upside down) is to get the property sold, particularly if the owner is delinquent.  All other considerations should be secondary for overlooking this point means that the house will be foreclosed with all of those negative implications.  Beyond that, he indicated something that really goes against common belief.  That is, when you do a Short Sale, it is most important to agree to a price that is particularly low so as to maximize the ability to use the insolvency exclusion of the debt cancellation tax provisions.  Sounds backwards but it is true.  If there is a bigger loss, it is easier for the Seller to have a bigger insolvency gap and it is more likely that if they need the insolvency exclusion they will be able to qualify for it.

In summary, the US tax code does indeed have provisions that help benefit both Homeowners and Investors alike from the potentially crippling tax effects of Debt forgiveness that they would be otherwise exposed to in the case of a Short Sale or Foreclosure action.  In addition, when using the insolvency exclusion there may be a very STRONG incentive to have the settlement price of the house be as low as possible so as to strengthen the case for insolvency.  This is particularly useful for Investors facing a Short Sale situation.