1. What are the benefits of a Short Sale vs. Foreclosure?

2. Can I short sale an investment property? (Yes)

3. Can the debt forgiven on a short sale or foreclosure be taxable income? (Yes)

4. Is it possible to have a taxable gain after a short sale or foreclosure? (Yes)

5. Can the lender come after me for a deficiency judgment after a short sale or foreclosure? (Yes)

This article is intended to provide general information to provide general guidance and dispel many myths on the topics of taxability and personal liability after a short sale or foreclosure. I am a Real Estate Broker and non-practicing Certified Public Accountant, however this is not intended to be tax advice and you should always consult with your own CPA, attorney and trusted advisors to discuss your specific situation, goals, rights and options.

That said, grab a cup of coffee and hang on tight ...

Definition - Short Sale

A "short sale" occurs when you sell a property you own for less than the combined loans on the property, and you get the lender(s) and other lien holders to accept less than they are owed. This is accomplished with a seasoned real estate broker and top notch negotiation team. This can be accomplished at no cost to the homeowner (reference www.ZeroShort.com).

Definition - Recourse vs. Nonrecourse Loans

In California, most first and second loans that are used to purchase a owner occupied residence are nonrecourse, but loans from refinancing a previous mortgage, equity loans and lines of credit are usually recourse. A recourse loan means that the debtor may remain personally liable for the debt even after a short sale or foreclosure. (see DEFICIENCY JUDGMENTS below)

DEFICIENCY JUDGMENTS

If you have a recourse loan, the lender may still come after you for the balance of your loan even after a foreclosure or short sale. If possible, attempt to get the bank to accept "payment in full without pursuit of any deficiency judgment" during your short sale negotiation.

Note that a lender who uses a non-judicial foreclosure (most common in California) gives up the right to a deficiency judgment. This does not apply to the second lien holder in a foreclosure. In both a short sale and foreclosure, second lien holders can obtain a deficiency judgment unless the loan is nonrecourse (see definition above).

Often, a recourse lender will issue a 1099 for the difference between what they were owed, and what, if anything, they collected. This may create taxable cancelation of debt income. However, there are many exceptions which would preclude a taxpayer from owing this tax. (see TAXABLE CANCELLATION OF DEBT INCOME below)

It's important for you to know that the lender cannot pursue a deficiency judgment and issue a 1099. They can only do one or the other, not both. In other words - you either have to worry about a deficiency judgment or taxable cancellation of debt income, but not both.

If it turns out that your worry is a deficiency judgment, bankruptcy may be an option to explore with your attorney to discharge the judgment. And there are certainly other options to consider including negotiating payments, a reduced amount or some other arrangement.

Table:  Can a lender pursue a deficiency judgment?

                                                                        Non-judicial Foreclosure                  Short Sale

Purchase Money - 1^st Lien                              No                                                       No

Owner Occupied, 1 - 4 units

Purchase Money - 2^nd Lien                             No                                                       No

Owner Occupied, 1 - 4 units

Non purchase Money - 1^st Lien                      No (for lender who forecloses)           Yes *  

Vacation, Investment Property                       (under "single action" rule)

Non purchase Money - 2nd Lien                   Yes                                                      Yes *

Vacation, Investment Property

* If possible, attempt to get the bank to accept "payment in full without pursuit of any deficiency judgment" during your short sale negotiation.

Taxable cancellation of debt income from a foreclosure or short sale:

In a foreclosure, the amount of "cancelled debt" is generally taxable unless an exemption applies.

Here's the formula:

1. Enter the total amount of the debt immediately prior to the foreclosure.___________

2. Enter the fair market value of the property from Form 1099-C, box 7. ___________

3. Subtract line 2 from line 1.If less than zero, enter zero.___________

The amount on line 3 will generally equal the amount shown in box 2 of Form 1099-C. This amount is taxable unless you meet one of the exceptions below.

Here are the exceptions: (Call your CPA to discuss your specific situation)

1. Mortgage Forgiveness Debt Relief Act of 2007 - Amends the Internal Revenue Code to exclude from gross income amounts attributable to a discharge in the years 2007 - 2012, of indebtedness incurred to acquire a principal residence. Limits to $2 million the excludable amount of such indebtedness. Note: The California version has lower limits and EXPIRED on January 1, 2009, making the entire amount subject to California Tax unless another exception applies. Check out the details at http://www.ftb.ca.gov/aboutftb/newsroom/mortgage_debt_relief_law.shtml
2. Bankruptcy: Debts discharged through bankruptcy are not considered taxable income.
3. Insolvency: If you are insolvent when the debt is cancelled, some or all of the cancelled debt may not be taxable to you. You are insolvent when your total debts are more than the fair market value of your total assets. Insolvency can be fairly complex to determine - be sure to contact your CPA.
4. Non-recourse loans: A non-recourse loan is a loan for which the lender's only remedy in case of default is to repossess the property being financed or used as collateral. That is, the lender cannot pursue you personally in case of default. Forgiveness of a non-recourse loan resulting from a foreclosure does not result in cancellation of debt income.

Taxable GAIN from a foreclosure or SHORT SALE.

Yes, at first it seems crazy, but you could likely have a taxable gain on a foreclosure or short sale.

For a recourse loan, the property is treated as being sold for its fair market value on the date of foreclosure. (For a short sale, FMV is the actual net sales proceeds). For a non-recourse loan, the property is treated as being sold for the balance of the mortgage.

In other words, the debt cancellation of a non-recourse loan is included in the sale proceeds or added to the FMV. This means, that while there is no taxable cancellation of debt income, there is a higher taxable gain on the sale.

Here's the formula to calculate the gain:

1. Enter the fair market value of the property foreclosed (or net sales proceeds from a short sale). For non-recourse loans, enter the amount of the debt immediately prior to the foreclosure. __________

2. Enter your adjusted tax basis in the property. (Usually your purchase price plus the cost of any major improvements.) ____________

3. Subtract line 2 from line 1. If less than zero, enter zero. __________

The amount on line 3 is your gain from the foreclosure of your home. If you have owned and used the home as your principal residence for periods totaling at least two years during the five year period ending on the date of the foreclosure, you may exclude up to $250,000 (up to $500,000 for married couples filing a joint return) from income.

For non-recourse debt short sales when the seller and buyer require the cancellation of the debt by the lender as a condition of the sale, the debt cancellation is included in the sale proceeds, like for a foreclosure.

SHORT SALE vs. FORECLOSURE

What will be the effects on my future loans?

Fannie Mae backed mortgages will be available to you following a short sale after two years. Fannie Mae backed mortgages will not be available to you for at least five years if you have lost your home due to a foreclosure.

Future Loan with any mortgage company

On any future 1003 Application (Standard Loan Application), a prospective borrower will have to answer YES to question C, in Section VIII, that asks, "Have you had property foreclosed upon, or given title or deed in lieu thereof?" This will affect all future credit rates. There is no similar question regarding short sales.

Credit History

Foreclosures will remain on your credit history for 10 years. A short sale is not report on a credit history. However, both will impact your credit score.

Does it affect my employment opportunities?

A short sale does not appear on a credit report and will not challenge your current employment status. In comparison, if you have a foreclosure on your credit report, some employers consider it a reason for termination or reassignment since many run credit checks on employees for certain positions. A foreclosure can be extremely harmful to your chance of being selected for a new job if your credit report is taken into consideration.

We hope you find this summary useful, concise and worthwhile. Feel free to bookmark the article for future reference as it's a complicated subject that rarely sinks in during the first read. Most importantly, before making a decision regarding real estate, including a short sale or foreclosure - consult with your trusted tax, legal and real estate advisors.