What's the Problem with Real Estate Short Sales?

There is a really big problem with (Real Estate) short sales. Financial authors don't seem to be mentioning this problem, and economists don't seem to be building this issue into their projections. First, let's describe what a 'short sale' is, not a stock market short sale (which is totally unrelated), but real estate short sales. A real estate short sale is when a homeowner, who is unable to make the payments on their house, put their house up for sale at a price below the amount of the mortgage, with the agreement of the mortgage company or bank that holds the mortgage.

The advantage to the homeowner is that no mortgage payments have to be made while it is listed, they get to live in the house tax-free, and a foreclosure doesn't show up on their credit report. The advantage to the bank is that they don't have to foreclose, they don't have to maintain the house , and they don't have to get into the business of reselling the home. They also don't get stuck with an illiquid asset that hurts their balance sheet.

But here is the timebomb. All homeowners who sell their property under a short sale are subject to paying tax on the amount forgiven. Escrow companies will send out 1099 forms, so the IRS will be fully aware of the homeowner's tax obligation. Sorry, the Homeowners Exemption on Gains doesn't apply.

Here is what it says at the House of Representatives Ways and Means web site, which has the Statement of National Association of Realtors:

The news reports have not mentioned the tax problem that sellers in short sales and foreclosures will face if lenders forgive (i.e., do not require payment on) some or all of a mortgage debt at the time of disposition. These sellers just might get a visit from the IRS.

Current Law. Any lender that forgives debt is required to provide a Form 1099 information report to the borrower and to the IRS stating the amount of the forgiven debt. The Form 1099 is required in any circumstance when a debt is forgiven, whether it is a short sale, foreclosure, deed in lieu of foreclosure or any similar arrangement that relieves the borrower of the obligation to pay some portion of a debt.

I know someone who is going through a short sale now at $160,000 below the outstanding mortgage. I'm sure he doesn't know about the tax consequences. At a 28% Federal tax bracket plus the high state bracket (for California), he may owe in excess of $50,000. This is for someone who can't afford a $3800 per month mortgage. What is he going to do about the tax? What are all the thousands and thousands of short sellers going to do? What is the IRS going to do? If they issue a lot of liens, the short sellers won't be buying any houses, cars, or any other confiscatable assets for a long, long time.

Comments

[Chuck Allen:]

To help this crippling situation in the housing market, the Fed could relax its regulations pertaining to reserves for bad debt.

Everyone is a loser in the current situation - the relaxation of the reserves for bad debt would allow for more forebearance to be available from the lender to the homeowner.

Chuck Allen
[e-mail]

2007 Aug 14 10:53 AM

[sawdust46:]

Are you nuts... The idiots that got themselves in this situation should be held responsible and pay their debts, just like the rest of us.

2007 Aug 14 09:50 PM

[mike1981:]

For a way for homeowners to minimize the income tax effect on real estate short sales, check out the following blog post at The Home Equity Theft Reporter:

Dodging The Income Tax On Foreclosure & Real Estate "Short Sales", link at:

HomeEquityTheft.blogsp...

Mike Morris

2007 Aug 14 11:30 AM

[Alan Bennin...:]

The original author ( Stockerblog ),has again done a big disservice to the reading public...they attempt to write about a subject without knowing the correct facts and the subject matter.
Homeowners in a foreclosure situation don't get to live Tax Free" let alone free and they don't have to put their home up for sale...more on this matter to follow. Mortgage payments will continue to be assessed...even if the payments are not made.

The basic premise of a short sale is: the lender is willing to accept a discounted payoff of the note and release the homeowner from the debt obligation. If the lender does not accept...there is no short sale. The homeowner, a real estate agent or an investor can attempt a short sale. If the short sale is accepted it is a three way win...the home homeowner wins by getting out of the debt. the lender wins because they tend to lose less money than going through the full foreclosure and the investor or end buyer wins because they have gotten a property at a big discount.

The investor will ask for "full satisfaction" of the debt in negotiations. The lender has two choices at this point: to pursue a deficiency judgment or to issue a 1099. Most lenders don't pursue the judgment. Depending upon the homeowner's solvency or insolvency at the time, will determine their tax liability. Homeowners need to speak with their accountant to file the correct forms required to prove insolvency. Generally the tax ramifications aren't as onerous as perceived.

Alan Bennington

2007 Aug 14 02:43 PM

[lexusguy1:]

yes he should be aware of the real facts before making such statements..

There is a little known form at the IRS, that when you fill in and prove your insolvency at time of short sale they will automatically forgive the tax indebtedness. Few know about this.

2007 Aug 14 05:03 PM

[Alan Bennin...:]

Thanks lexusguy...I'm a Chevy Suburban guy...whatever. Thanks for knowing your subject too.
IRS Pub 544 is the needed form form for homeowners when they file their taxes.

I don't mean to "dump" on Stockerblog but I'm an investor who helps people in foreclosure everyday. I do lender loss mitigation to keep people in their home if possible, I do short sales or can buy the property other ways and I also help with credit restoration. All of this is of help to the homeowner...preventing a foreclosure or bankruptcy or further erosion of their credit.

I see so much incorrect information being spread around by people innocently or maliciously. I just have to say something out of frustration...especial... when people and groups talk about investors stealing your house. It does happen at times, but there are ethical people like myself working and helping on a daily basis.

Alan Bennington

ralanar850@bellsouth.n...

2007 Aug 14 07:07 PM

[david darby:]

Thanks for the info on that form 544 I had a foreclosure in december 2006 and the house sold in jan 2007. I may need this form. Although when I talked to the lender I asked them what I owed them and they said my account was zero and I owed nothing.

David

2007 Aug 15 01:07 AM

[WHYME:]

Owing the lender and owing the IRS -> two entirely different situations!!! Filing the 544 is about the only way out short of filing for BK..

2007 Aug 15 12:56 PM

[WHYME:]

One last comment... Any tax due the IRS resulting from debt forgiveness is due on April 15th IN FULL -- not amortized over a period of years -- unless you can negotiate a payment plan with the IRS..

But, all in all, I would rather pay 28% of my debt than be held to the full amount of the debt forgiveness.. as in a deficiency judgment.

2007 Aug 15 01:07 PM