The Real Estate Blog

Is Debt Forgiven in a Short Sale?

December 5th, 2012 10:29 AM by Wendy Thomas

    If you've heard that the Mortgage Debt Relief Act of 2007 wasn't renewed and will expire the end of 2012, you may be wondering what that means for the future of short sales.  I've found some great information that answers our questions.... Read on...

First, let’s recap what the Mortgage Debt Relief Act of 2007 does. The Act provides for protection for some sellers regarding the tax liabilities from the 1099-C received when a lender forgives their debt. In plain English, when a lender waives deficiency, that amount is “Forgiven” debt, and a 1099-C is issued. According to IRS rules, this forgiven debt is to be considered as “income,” and therefore subject to be taxed. While wholly unfair to the seller, since this is not actually income received, it is, nonetheless, law. The Act protected those who are selling primary residences, and usually applies only to first liens, credit lines used for purchase money or home improvement. In other words, it was a major selling point in a seller’s consideration of how to address their selling situation, and one that made a short sale attractive over a Deed in Lieu or a foreclosure.

The Fear
Many agents fear that without the protection of the Act, short sales will cease to be an attractive option for homeowners, but I believe that this is unwarranted. The main reason for this is that, at least for me, about 40% of short sales do not qualify for the protection of the Act right now, and yet; sellers still feel that the benefits outweigh the risks. Further, new GSE (Fannie/Freddie/HUD) guidelines are making full deficiency waivers more of a certainty than in the past. Moreover, it is extremely rare that sellers not protected by the Act actually owe a tax liability. Let’s take a look at these three major points in depth:

Protected vs. Unprotected Property
As of now, even with the Act in force, only primary residences are covered. This means that a large percentage of sales are not covered. There are certainly many sellers who are liquidating investment properties and second homes. The benefits afforded to these sellers are manifold, including:

• The chance for a full deficiency waiver
• Avoidance of a foreclosure on credit
• Psychological benefit: Taking action and selling vs. letting bank foreclose

Tax Liability vs. Deficiency
It is important for agents to understand this difference, because confusion of these terms is commonplace.

Deficiency: The difference between what the lender nets on sale versus what the borrower owes. This difference will be reflected on the 1099-C issued by the lender.

Tax Liability: This is the amount that may be considered forgiven debt, and therefore, income, based on current IRS rules. This is what is currently covered in some cases under the Mortgage Debt Relief Act.
In other words, Deficiency is what you owe the bank, and Tax liability is what you owe the IRS, and the two are not mutually exclusive.

New Guidelines
As of November 1, 2012, the major Government Servicing Entities (GSE’s) such as Fannie Mae, Freddie Mac, and HUD, have amended their guidelines to include a full deficiency waiver for most sellers. This is an important development, because the deficiency waiver preserves the most valuable benefit of a short sale for the sellers. The ability to complete a short sale and be virtually guaranteed a full release on the first lien is a major step in the direction of solidifying the short sales place in the market. In most cases, a full deficiency waiver means more to a seller than tax liability protection.

Tax Liability
This section is not intended to give legal advice, and I am not an attorney. It is my position on ALL short sales, that the seller has competent legal representation. I work very closely with attorneys in the short sale process, and here are the reasons why most attorneys and CPA’s will agree with my assessment on tax liability;

On a short sale not covered under the Act, the seller’s lender will issue a 1099-C-forgiveness of debt. This can be counteracted in several ways. The most popular are:

• IRS Form 982. This is the insolvency test. In many cases, regardless of income or assets, a sellers paper debt meets or exceed their assets. In such a case, the seller may be legally insolvent, thus exempting them from tax liability. In other words, all debts, including all mortgages (which are most likely underwater) count towards liabilities. This is especially helpful for sellers with more than one property. In all cases I have seen where sellers, even showing significant assets, Once they showed their liabilities via this form, the insolvency test was passed and they were not liable for taxes owed. To find out if your seller qualifies, always refer to a competent attorney or CPA.

• Loss on Sale. This is another way that a good CPA can offset tax liability. The 1099 income will be reported, but the loss on the sale should counteract this income. The loss will include the difference between selling price and purchase price, plus any down payment the seller put into the transaction.

If you have any questions regarding short sales as a buyer or a potential seller, call me! I'll be glad to help.


Originally posted by Posted by Joseph C. Alfe on December 2, 2012 , Short Sale Specialist Network

Posted in:General
Posted by Wendy Thomas on December 5th, 2012 10:29 AM


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