Re: Tax question regarding Short Sale… - Posted by Dave T
Posted by Dave T on March 14, 2000 at 10:44:03:
Maybe not, it depends. There isn’t a simple answer since the issue itself is complicated, but let me give a general summary and the short sale pitfall to watch for.
The general rule is that cancellation of debt (COD) is taxable ordinary income and results when any of the borrower’s debt is reduced for less than the full amount due. COD most commonly results when restructuring or settling a loan.
The solvent borrower is subject to an immediate tax from the income created by the COD. The problem is that this reduction in mortgage debt does not produce the immediate cash flow necessary to pay the tax associated with this “phantom” income.
There is an exception to the COD income rule. If the COD, in whoe or in part, occurs (1) in bankruptcy, (2) to an insolvent borrower, or (3) with qualified farm debt, the COD income is not taxable.
When the taxpayer is insolvent, COD income is excluded from gross income. However, the amount excluded CANNOT EXCEED the amount by which the borrower is insolvent. Being insolvent means the taxpayer’s liabilities exceed the fair market value of his/her assets immediately before the discharge.
Of course as another complication, the amount of COD realized (usually the amount of debt forgiven) may be different depending upon whether the borrower is personally liable (recourse debt) or not personally liable (non-recourse debt).
And now for the pitfall with a short sale to watch out for. Many financially troubled transactions combine both a sale AND cancellation of debt. If the cancellation of a loan is part of the sales price and NOT a stand-alone cancellation of debt, it is NOT excluded by the insolvency relief provision and IS taxable.