1099; Short Sale vs Foreclosure Sale - Posted by redave

Real Estate Investing Real Estate Law
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Posted by JT-IN on May 07, 2007 at 20:37:20:

Dave:

My read is the same as yours, that the tax treatment of a short sale and a foreclosure (assuming that bid price at auction were the same as the short sale), is exactly the same. Both having potential of taxable income to the debtor in the amount of forgiven debt.

The other aspect is this… what about the 1099C being sent by the lender, a financially culpable debtor not eligible for exclusion from taxable income due to insolvency, then having the lender pursue a deficiency judgment… I guess they wouldn’t do both; if the lender pursues the def, then the debt isn’t forgiven… A deep subject, really.

Way too much is made of this “potential taxable income from a short sale” business. I would say that 98% of all those who qualify for the ss, will meet the test of being insolvent, therefore not subject to the taxes on the financial benefit received. After all, the measurement of insolvency is prior to the forgiveness of the debt, and most folks will meet the exemption or the lender wouldn’t agree to the short to begin with, IMO.

Thanks for the ideas Dave.

JT-IN

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1099; Short Sale vs Foreclosure Sale - Posted by redave

Posted by redave on May 06, 2007 at 10:33:46:

All,

If a homeowner sells a house and the payoff is short, let?s say $100k short, they will get a 1099 for $100k from the lender and will have to pay taxes assuming they don?t qualify for an insolvency exemption.

If that same homeowner let the property got to foreclosure sale where the property went back to the lender, is the sale considered for the loan balance thus no 1099 to the homeowner?

Thanks, Dave

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Re: 1099; Short Sale vs Foreclosure Sale - Posted by Dave T

Posted by Dave T on May 06, 2007 at 13:51:14:

Yes, that is correct as far as the IRS is concerned. However, if the lender is unable to sell the property as an REO for enough money to cover its investment, the defaulting homeowner may still get a deficiency judgement

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Re: 1099; Short Sale vs Foreclosure Sale - Posted by Dave T

Posted by Dave T on May 06, 2007 at 13:49:26:

Yes, that is correct.

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Read Publ 544, pg 5 - Posted by JT-IN

Posted by JT-IN on May 06, 2007 at 16:32:00:

Dave T:

After reading Publ 544, pg 5 (top of col 1), I disagree with your answer here.

If the FMV of the property being foreclosed upon is LESS than the amount owed, the difference results in forgiveness of debt, and potentially taxable income.

I respect your tax knowledge and have learned many times from your answers over the years, however I reach a different conclusion after reading the above Pub. Re-read and comment please. :Let me know what I am missing, or reading into this issue…?

Thanks.

JT-IN

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Re: Read Publ 544, pg 5 - Posted by Dave T

Posted by Dave T on May 07, 2007 at 22:14:15:

JT-IN,

You are right. My brain was clearly asleep when I wrote that. I will try not to let that happen again.

Here’s how I see it when recourse debt is involved and the property is lost by foreclosure.

A foreclosure is deemed to be a taxable sale. As a result of foreclosure, the defaulting borrower could be the beneficiary of capital gain (or loss) created by the foreclosure, and, income from the discharge of indebtedness.

The gain (or loss) from foreclosure is determined by the difference between the actual sales price (or FMV if there is no sale) and the defaulting borrower’s adjusted cost basis.

Cancellation of indebtedness income as a result of the foreclosure is the amount of the debt discharge that exceeds the actual sale price (or FMV if there is no sale).

For example, Dave purchases a single family rental property for $125K using $95K in recourse debt. After several years of rental use, Dave has accumulated $75K in depreciation making his adjusted basis in the property equal to $50K. Meanwhile, he has paid his mortgage loan balance down to $75K.

Dave falls on hard times and stops paying the mortgage. The lender forecloses and the property sells for $65K on the courthouse steps. The lender decides that Dave has no other assets worth pursuing so it decides to forgive the balance of the mortgage debt.

The sale price was $65K while Dave’s adjusted basis is only $50K. Dave has a taxable capital gain on the sale of $15K. In addition, since the loan balance was $10K greater that the sale price and the lender decided to forgive that amount of indebtedness, Dave also has ordinary income from cancellation of debt.

Even though Dave received no money from the foreclosure sale, the IRS will still tax his $15K gain on the sale of the property. The $10K cancellation of debt income is also taxable as ordinary income unless it could be sheltered by bankruptcy and insolvency relief provisions in the tax code. Of course, there is no cancellation of debt income if Dave remains liable for the deficiency (i.e. a deficiency judgement is granted).

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Re: Read Publ 544, pg 5 - Posted by redave

Posted by redave on May 07, 2007 at 13:06:45:

Thanks for the reference to pub 544?very intereting.

Seems to me the whole thing turns on the defination of Fair Market Value.

Consider this scenario: If the Debt, FMV and Basis were all $389k, which is realistic for a homeowner that bought with 100% financing, defaulted, then sold short. According to the pub 544 formula on page 5, the cancellation of debt is zero and the Gain from foreclosure is zero. I?m going to talk here about a short sale, but the same logic seems apply to a foreclosure sale.

I?m thinking FMV bears no (or little) relation to the short sale price. Why? Because of the IRS defination of Fair Market Value in the same pub on page 3.

?Fair market value. Fair market value (FMV) is the price at which the property would change hands between a buyer and a seller when both have reasonable knowledge of all the necessary facts and neither has to buy or sell.?

Notice the part about ??neither has to buy or sell.? Well, the short sale buyer ceratinly doesn?t have to buy, but, the seller HAS to sell because of the pending foreclosure. Therefore the FMV is not the short sale purchase price but must be determined by someother means, like a recent appraisal.

How about them apples.

Dave

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Now use Pers Res e.g. for short sale - Posted by JT-IN

Posted by JT-IN on May 08, 2007 at 14:03:39:

Dave T:

Appreciate the example of the short sale on the investment property. I believe your analysis is correct, and if not, it is certainly beyond my vat of knowledge on the subject… so we will concede you are correct anyway. :slight_smile:

Since the vast majority of short sales are from a primary resid standpoint, and likely a 2 of 5 yr exemption involved, how about if you rethink the scenario through using numbers on a primary resid situation…?

Thanks for your thoughts on the theoretical problem.

JT-IN

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Assume Short Sale for $65k… - Posted by redave

Posted by redave on May 08, 2007 at 11:00:45:

Is the tax scenario the same?

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Re: Read Publ 544, pg 5 - Posted by JT-IN

Posted by JT-IN on May 07, 2007 at 14:51:13:

Dave:

You make some valid points on the definition of FMV, especially with the use of the IRS own definition, and the lack of fit to an actual short sale. However, using practical examples of ss that occur, the figure used to determine a 1099 (when sent) is the sale price of the short sale, not an appraisal value or even the BPO.

After reading the Publ 544, regarding the foreclosure and forgiveness of debt, don’t you agree that the net result of an actual sheriff or trustee sale DOES result in a potentially taxable event, and the obligation of the foreclosing lender to send the 1099C to the Debtor…? It seems quite clear to me that this obligation exists just the same as if a short sale existed. (Sans the argument over FMV).

Certainly the right would exist for any debtor who was foreclosed upon to challenge successfully the amount of forgiveness and true FMV, although this is rarely a concern due to the insolvency status of most debtors having gone through the process.

Interesting, and like many things with the IRS, the question seems to raise more questions than solid answers. Any other thoughts on the requirement on the foreclosing lender to actually send the 1099C to the Debtor…?

Thanks.

JT-IN

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Re: Now use Pers Res e.g. for short sale - Posted by Dave T

Posted by Dave T on May 09, 2007 at 06:15:55:

No problem.

The situation is identical to the previous example. This time the property is a primary residence instead of an investment property, so there is no depreciation involved.

The capital gain and cancellation of indebtedness calculations are the same. If the short sale or foreclosure sale price is greater than the borrower’s cost basis, then there is a taxable capital gain that could be excluded from taxes under Section 121.

If the borrower has a loss, then there is no deduction because tax losses on a primary residence are not allowed.

If there is cancellation of indebtedness income, it is ordinary income and not eligible for Section 121 exclusion. This income could still be sheltered under the bankruptcy and insolvency provisions, however.

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Re: Assume Short Sale for $65k… - Posted by Dave T

Posted by Dave T on May 09, 2007 at 06:17:54:

Yes. Just replace foreclosure with short sale in the example. The calculations are the same.

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Re: Read Publ 544 & 523, pg 5 - Posted by redave

Posted by redave on May 07, 2007 at 20:08:22:

JT,

Looking at irs pub 544 pages 4-5, and irs pub 523 pages 4-5, side-by-side, you can get a little bit better perspective. I don?t think fmv plays as significant a role as I indicated earlier.

The question of lender?s duty to send a 1099 is answered in pub 544 page 5?an institutional type lender is required to send a 1099 (?A? if no debt cancellation, ?C? if any debt is cancelled) if it acquires an interest in the property. It doesn?t address the non-interest acquiring lender, like a short sale. Also, there doesn?t seem to be a requirement for a non-institutional lender to send a 1099, like an individual foreclosing on a seller carry-back for example.

The taxable gain for a foreclosure sale looks to be the total amount of the cancelled debt minus the taxpayer?s tax basis, plain and simple, regardless of fmv, regardless of foreclosure sale amount. This is for non-recourse debt.

For recourse debt, the taxable gain on the sale seems to be the fmv minus cost basis, plus ordinary income in the amount of cancelled debt minus fmv, when fmv is less than cancelled debt. Seems the total taxable amount would be the same as non-recourse debt under some circumstances and somewhat different under others, depending on such things as capital gains treatment, fmv, etc.

I wish the pubs gave a short sale example, but I don?t see it. I want to say the taxable gain on a short sale would be the same as that of a foreclosure sale but I don?t really know.

Anyway, wouldn?t it be something if there turned out to be a significant tax advantage for the homeowner to go through with the foreclosure and not sell short!

Dave