Foreclosures and Short Sales, A Ticking Tax Time-Bomb for Panhandle

The number of foreclosures, short sales, and property owners simply handing over their keys remains at an all-time high.  Unfortunately, this trend will continue for the foreseeable future - as long as the number of owners “underwater” remains at an all-time high.

According to the Census Bureau, approximately 40% of all homes (dwelling units) in Berkeley and Jefferson County were built between 2000 and 2010.  The majority of those who purchased these homes have mortgages that exceed their home’s value.  Individuals who refinanced or obtained secured equity lines during the “bubble,” are in the same boat – owning properties submerged in debt – or as we have come to say – “underwater”. 

The trauma of losing a property to foreclosure or short sale cannot be overstated.  After months, often years, of struggle owners finally abandons the dream of ownership.  Emotionally detached from the property, they simply want to move on with their lives.  The last thing they need is more bad news.

More Bad News - A Tax Bill – the Ticking Tax Time-Bomb:  In too many cases this emotional detachment, combined with erroneous tax-myths, false assumptions, and flat-out misinformation, is creating a secondary crisis for beleaguered homeowners – a gigantic, computer-generated tax bill that arrives two or three years down the road.  The cause: under or misreporting “income” generated by the short sale, foreclosure or abandonment.  This column will briefly discuss: 1) How this income is generated, and 2) Why misreporting or under-reporting starts the countdown to possibly receiving a giant, unexpected tax bill.

“…But I’m Broke!”  One of the most common questions we receive regarding this topic is “How can I have taxable income when I’m broke?”  Unfortunately, the answer is relatively simple.  Here are two common, mathematically simplified, scenarios:

  1. Taxpayer A, John, buys a home in 2006 for $300,000 using 100% financing.  In 2012 he starts the process to short-sell the home.  In 2013 the short-sale goes through for $170,000 and the bank forgives the remaining $130,000 of debt.  As the IRS sees it, John has received $130,000 in potentially taxable income.  Potential Federal and State Tax (assuming 25% federal and 6% state tax rates in all examples): $40,300.
  2. Taxpayer B, Joan, purchased a home for $100,000 in 1995.  In 2005, when her home was suddenly worth $300,000,  Joan refinanced for $275,000 and used $200,000 of the proceeds to pay off bills, buy two cars, and send her children to college.  In 2011, after her home’s value dropped to $175,000, she handed over her keys to a trustee to avoid foreclosure.  As the IRS sees it, Joan has received $100,000 in potentially taxable income (loan of $275,000 minus the home’s $175,000 value).  Potential Tax: $31,000.

In both situations, John and Joan received the use and benefit of money they did not pay back.  When the bank forgives a debt for which an individual is personally liable it generates what is called Cancellation of Debt Income.  The bank is required to report Cancellation of Debt Income to the IRS and the taxpayer by submitting Form 1099-C.  If the taxpayer does not properly report this income, IRS computers will automatically “correct” their return and send them a bill for the tax due, plus penalties, plus interest.  It generally takes 8 to 15 months after the bank reports the canceled debt for the IRS to catch up to the taxpayer with a bill. 

There are currently five possible exclusions of Cancellation of Debt Income: 1) Debt Discharged in Bankruptcy, 2) Insolvency, 3) Qualified Farm Indebtedness, 4) Qualified Business Property Indebtedness, and 5) Qualified Personal Residence Indebtedness (scheduled to expire at the end of 2012 if not extended by Congress).  These exclusions, however, are much more restrictive than their titles suggest and require tax expertise to properly apply.

So, if you or someone you know is considering short sale, facing foreclosure or thinking of abandoning a property, obtain Tax Professional assistance BEFORE acting.  Also, have an experienced tax professional prepare this year’s return.  It can save you thousands.  If you have any questions or need assistance, please feel free to contact our office at 304-267-2594 to speak with a tax professional.

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.