Tax issues explained for short sale of homes

By Sheryl Rowling

SAN DIEGO  — Dear Money Maven: Senator  Barbara Boxer released information on the tax rules related to a short sale, but I don’t understand what it says! Can you take a look  and explain it to me?

A: I will certainly try! Here’s the story:

In August 2013, Senator Boxer asked the IRS if a California homeowner would have taxable income from a lender- approved short sale. She asked this question because the tax law excluding income from loan forgiveness on a principal residence was set to expire at the end of 2013.

In its original response to the Senator in September 2013, the IRS explained that for short sales occurring after 2013, when the mortgage amount exceeds the fair market value of the home, the taxpayer would report the entire amount of the loan balance as proceeds from selling the home.  Let’s assume that the mortgage balance was $300,000, the home was worth $200,000 and the taxpayer originally paid $350,000. The taxpayer would be treated as selling the home for $300,000, realizing a $50,000 loss (since the cost was originally $350,000). The loss would not be deductible since it would be a personal loss. On the other hand, let’s assume the same facts except the taxpayer originally paid $250,000 for the home.  The gain would be $50,000.  However, this gain could be excluded from income under the primary residence gain exclusion (up to $250,000 for singles or $500,000 for married couples).

A few weeks ago, the IRS sent Senator Boxer a new letter clarifying these rules. According to the IRS, the above treatment only applies to the original mortgage used when buying the home.  For a mortgage that was the result of a refinance, a second or home equity loan subsequent to the original purchase, any debt forgiveness would be treated as income.
This new letter did not sit well with our Senator.  A few days ago, she wrote back to the IRS stating, in part, “Finally, what is the IRS’s position on homeowners who completed a short sale in the first part of this year while relying upon the earlier letter? I am concerned that the current letter, with its more narrow analysis, may have negative consequences for some homeowners who made a good faith decision to go through with a short sale based on the earlier guidance… it seems unfair to subject a short seller to unanticipated cancellation of debt tax liability if they would not have been subject to such liability, and had acted with this understanding, under the analysis of the earlier letter.”

So what does it all mean? It means that if you do a short sale in 2014, you will likely have no tax liability if the mortgage involved was from the original purchase.  If the mortgage was from a refinance, a second or home equity loan, you could be facing a tax bill.  But know that our mensch Senator Boxer is trying to get the IRS to waive tax in the latter case for short sales occurring  in 2014 prior to September.

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Sheryl Rowling is a certified public accountant, personal finance specialist, and principal of Rowling & Associates. She may be contacted via sheryl.rowling@sdjewishworld.com