Foreclosure, Abandonment, and Short Sales

The slumping housing market is not news.  If you purchased or refinanced a home, a second home, or rental/investment/business property from 2002 to 2008, you probably owe more on that property than it is worth – referred to as “upside down.”  If you’re in this situation you are not alone.  Nationwide 23% of homeowners find themselves owing more on their home(s) than their home(s) is worth.  In some regions, such as many areas in Nevada, upwards of 65% of homeowners are finding themselves “upside down” in their mortgages.

Definitions and Consequences:  A “short sale” occurs when the mortgage holder allows the property owner to sell at a price less than the balance owed on the mortgage.  Abandonment occurs when the owner leaves the property and the mortgagee takes possession.  Generally, the property is foreclosed upon later. Foreclosures occur when the mortgagee takes legal title to a property. 

When a property is sold short, abandoned, or foreclosed upon, two potentially taxable events occur. 

First, a “sale” has occurred.  A property that is sold short is sold in a normal sales transaction although the sales price is less than the amount owed on the mortgage.  When a property is abandoned or foreclosed upon there is no contractual sale but the property is, in effect, sold to its creditors.  These “sales” may result in taxable capital gain or deductible loss (note that losses on personal-use property, such as a residence, are not tax deductible). 

Second, short sales and foreclosures may also result in taxable income if any portion of the mortgage is forgiven (unless a specific exception applies).  This income is called Cancellation of Debt Income.

Calculating Capital Gain/Loss:  In order to calculate the taxable gain or loss from a short sale or foreclosure, the property’s sales price must be determined.  For a short sale this is relatively easy.  The sales price is the contract price.  Determining the sales price of a foreclosed property is a bit more complex.  The “sales price” of a foreclosure will depend on whether the property’s mortgage is “recourse” or “nonrecourse.”  Recourse loans are loans the borrower remains personally liable for after foreclosure.  Nearly all mortgages in WV, VA, MD and PA are recourse mortgages.  For recourse loans, the “sales price” is the lesser of the loan amount or the fair market value of the property. 

Once “sales price” is determined, the capital gain or loss is calculated by subtracting the owner’s investment, called “basis,” from the sales price.  Generally, the owner’s basis includes (but is not limited to) original purchase price plus capital improvements (such as additions, etc.).  If the difference between sales price and basis is positive, there is capital gain; if negative, a capital loss.  If there is a capital gain and the owner lived in the property as their primary residence for two of the past five years, he may be able to exclude all or a portion of the gain from income.  A capital loss on business or investment property may be deductible.  Losses on personal-use property, however, are not tax deductible.

Cancellation of Debt Income (CODI): Cancellation of debt income can occur when the amount of recourse debt exceeds the property’s fair market value (or sales price if the property is sold) and the bank forgives the remaining debt.  This cancelled debt will be taxed as ordinary income unless an exemption applies.  These exemptions include (but are not limited to):

  1. Debts discharged in bankruptcy,
  2. Insolvency immediately before the debt was forgiven,
  3. Qualified Farm Debt,
  4. Qualified Real Property Business Debt, and
  5. Qualified Principal Residence Indebtedness.

The Bankruptcy exclusion is fairly straight forward and must occur before the debt is cancelled.  Proving insolvency, however, requires additional calculations.  The qualified real business property and principle residence debt applies only to “qualified acquisition debt:” debt (including refinanced debt) used to acquire, construct or substantially improve the property.  Any debt forgiven that is not qualified acquisition debt will be taxable unless another exemption applies.

This brochure provides basic information regarding the tax consequences of short-sale, abandonment, and/or foreclosure.  These complex issues may require the assistance of a qualified tax professional to minimize tax liability.  If you need assistance, we would be honored by the opportunity to assist you.  Please be sure to contact our office before you face a short sale, abandonment, or foreclosure.

Further Reading

Brett Hersh's avatar
  • Author: Brett Hersh
  • Bio: Brett Hersh, EA, MBA, is the owner of HBS TAX & Small Business Experts. He is an Enrolled Agent (EA) with the IRS and licensed by the US Treasury Department to prepare all tax returns and represent taxpayers before the IRS for audits, collections and appeals. He is also Dave Ramsey’s ELP for Tax and Accounting, a continuing education instructor for tax professionals through Lorman Education, and a local speaker/presenter on the topics of tax and business growth. He can be reached at (304) 267-2594.