Under the Forgiveness Debt Relief Act of 2007, you have no tax obligations after a short sale until 2012. However, the status of tax liability in this case may change very soon.
A common misconception troubled homeowners frequently held before 2007 is that they were free of their tax obligations to the IRS after a short sale or foreclosure. Many learned the hard way that they had serious debt obligations to the IRS after the bank granted them debt forgiveness.
The aforementioned act of 2007 gave taxpayers some relief in this situation. Yet with 2012 upon us, the IRS tax code on debt forgiveness will revert back to normal. Expect the return of big taxes and fees on debt forgiveness.
Normally, in the eyes of the IRS, a foreclosure is a home sold. The former homeowner will be required to pay all outstanding taxes on the property and taxes associated with the ‘sale’ of the home—even if it was repossessed by the bank.
Discharge of indebtedness income
During a short sale, a bank may accept less than a home’s value because of a loss in market price or otherwise. However, the IRS will look upon the bank’s loss as your gain. Under ordinary tax code, this qualifies as debt forgiveness and is viewed by the IRS the same as income and profit, thereby subject to many of the same laws.
The IRS taxes debt forgiveness. If, for instance, you owed the bank $200,000 but sold the home at 150,000, you are liable for anywhere between 10-35% in sales or related capital gains tax on the $50,000 you were forgiven.
IRS law treats the forfeiture or sale of a home by the borrower as a means of gaining taxable income. However, the ‘beneficiary’ of the sale, the person or organization receiving the proceeds, is the bank or lender in case of foreclosure.
In the normal sale of a property, you would be expected, of course, to pay taxes on any gains you made from the sale of a property, but would realize personal gains from your investment. Once having considered their tax liability to the IRS for a foreclosure, many homeowners get cold feet. This tax liability can really hurt if a home is significantly underwater, and the bank loses a huge portion of their initial mortgage investment.