Taxation of Short Sales and Foreclosures

Taxation of Short Sales and Foreclosures

In this Analysis, Mark S. Ericsson discusses the tax consequences of a divestiture of property through a short sale (in which the lender agrees to take less than the loan balance), foreclosure, or deed in lieu of foreclosure. He writes:

     The focus of any inquiry as to the tax consequences is how much gain and how much cancellation of indebtedness is recognized in the transaction. Gain is the amount one realizes over the amount that on has invested, or how much the value increased. Income is realized to the extent that one's net worth increases, unless the income can be excluded by statute or case law. In the case of cancellation of indebtedness income, if the bank agrees to compromise a $20,000 debt to $10,000, one's net worth has gone up by $10,000 and that is income. As one studies the four schedules, he or she will note that two factors come into play. First, gain is taxed federally at a maximum rate of 15% (20% next year) while cancellation of indebtedness income is taxed at a maximum rate of 35% (39.6% next year). Therefore, any comparison must start with how much tax is generated at the two different rates.

     Secondly, both gain and ordinary income can be excluded. There is one exclusion for gain on principal residences, and there are five exclusions for cancellation of indebtedness income. Therefore, one must determine if one of the exclusions applies and if there is any detriment caused by applying the exclusion.

     The exclusion for gain is the $250,000/$500,000 IRC Sec. 121 exclusion for homeowners who have owned and occupied the home for two out of the last five year prior to sale. There are five ways to exclude income from cancellation of indebtedness income, which are found in IRC Sec. 108. They are the insolvency exclusion (taxpayer may exclude an amount of COD Income equal to the excess of the COD Income over the net worth of the taxpayer immediately after the sale); the bankruptcy exclusion (where personal liability has been eliminated by a bankruptcy before or within the bankruptcy); the election to exclude acquisition indebtedness under IRC Sec. 108(a)(1)(E); and two that rarely apply to personal residences or rentals (farms and property used in a trade or business).

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