Posted by Tim Burrell - The pain may have been lessened for some "short" sales. One of the problems with a "short" sale used to be that a seller had to pay income tax on the amount the payment was "short". A "short" sale is where a home is sold and the seller does not repay the full amount of the mortgage, i.e. the payment is "short". So, if you owed the bank $300,000 and you paid $250,000 when the sale closed, the $50,000 that you are short is taxed as ordinary income. That could cost you $14,000 to the IRS and more to the state taxing authorities.
The Mortgage Forgiveness Debt Relief Act of 2007 was just signed into law eliminating the income tax for some sellers whose sales close between January 1, 2007 and January 1, 2010. There are several requirements:
1. The property sold must be your principal residence, as defined in section 121 of the Internal Revenue Code.
2. The debt that is forgiven must be "Qualified Principal Residence Indebtedness", i.e. the money used to acquire a principal residence.
3. There is a limit of Two Million Dollars for the amount of non-taxable Debt Forgiveness, a limit that will not affect anyone in the Triangle.
These rules raise some questions. The biggest one is what is Qualified Principal Residence Indebtness. The law says "For purposes of this section, the term `qualified principal residence indebtedness' means acquisition indebtedness . . . with respect to the principal residence of the taxpayer." So, if you refinanced the house for more than what you owed and took money out to spend on other things, that additional amount is not covered by this law. For example, you had a loan of $200,000 when you bought the house. You refinanced it with a loan of $400,000, and used the additional money to pay off your other debts. If you sell the home and pay $350,000 instead of the $400,000 debt, this new law does not protect you from paying income tax on the $50,000 that was "short". If you take out a mortgage to buy the house, refinance it for the amount owed on that mortgage (and no more), then your payment to pay off the mortgage is $50,000 short, you will not pay tax on that amount.
Another question is do you need to have lived there for 2 years out of the five years before your home is sold, as that requirement exists to establish a home as your principal residence in order to avoid paying tax on the gain when you sell your primary residence. It does not make sense to impose that requirement based on the purpose and intent of the legislation, but there is a lot of the Internal Revenue Code that does not make sense.
One more question is what happens if you refinance the home and use the additional funds to remodel the home. Normally, that would increase your basis in the home, so it would decrease your tax liability if you sold the house. So, it would be logical to allow this type of refinancing to be subject to the protection of the new law. Again, it is hard to rely on logic when dealing with the IRS, so I hope there are some regulations developed to interpret this situation.
The amount of forgiven debt that is not taxed is subtracted from the basis of your next house, so that when you sell it, you have to recognize more gain on that sale. For example, you go short by $75,000 when you sell a home, you buy another one later for $400,000. Your basis is not $400,000, but $325,000 as the $75,000 is subtracted from your basis. So, when you sell it, you will have $75,000 more gain. Remember, there is an exemption from tax for $500,000 of gain for a married couple filing jointly, so this amount of additional gain could be covered by this exemption. Even if it is not, if you make more than $500,000 in gain and have to pay some tax, you should not cry.
One other good thing this law did was to extend the deduction for the payments for Mortgage Insurance to 2010. We used to avoid Mortgage Insurance in sales that did not have 20% down payment, as it was not deductible. Now it is.
It is hard to find the text of the law, but here is a link to how it looked when it passed, so you can read it for yourself. http://tinyurl.com/2qdnwj . This law is so new, and in need of interpretation, that if you find yourself in this situation, you need to consult a tax professional before you sell.
So, for people who bought a home, did not refinance it for more, and sold it for less than they owed, there is no income tax due on the short sale, so long as the sale is less than two million dollars short. This legislation eliminates one of the most miserable parts of a short sale, as it was obnoxious for a homeowner to loose all their equity, have to sell their house, and then get a tax bill.
If you have any thoughts on this, I enjoy comments.