Taxes Impacted by Short Sale Laws

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Madeleine Jones
October 10, 2016

Home For Sale Real Estate Sign, Short SaleSome homeowners may owe taxes on short sales. Homeowners in the Las Vegas area and around the country are struggling with mortgage debt. Even if this debt is forgiven during the short sale process, it is still considered taxable income by the IRS.

Short Sale Basics

Short sales happen when a homeowner sells a home for less than what is owed on the property. Lenders typically negotiate with homeowners and sell the property to a third party. This allows lenders to recoup at least some of the money from the original mortgage. The lender essentially forgives the remaining debt, after taking the profits from the sale of the home. It may also be a time and money saver for all parties because it eliminates the need for a foreclosure.

While there were many government relief programs in place that were specifically created to help Nevada homeowners keep their homes, many came to a close in December of 2016. This leaves millions of homeowners around the country in a tough spot, so more may turn to short sales as an alternative to foreclosure. Lenders do not always accept short sales, but attorneys are often successful with convincing them to forgive debt in this way.

The issue of negative equity is present in all areas of the country, but Nevada is dealing with quite a few homeowners in distress. Nevada ranks high for the number of housing units that have mortgages that are significantly underwater. A great number of these homes are in the Las Vegas metro area.

The Tax Implications of a Short Sale

Most homeowners who are considering a short sale are struggling financially. It’s not uncommon for people to worry about adding a tax bill to already mounting debt. Unfortunately, some owners do indeed end up owing taxes after a short sale. The IRS considers forgiven debt to be received income, and therefore taxable.

When the debt forgiveness law expired, so did protection against short sale tax bills. Even if the process of negotiating a short sale began before year’s end, it will not be exempted from taxation by the IRS. Unfortunately, these expenses can potentially run into the tens of thousands of dollars.

The federal tax code requires that mortgage debt that is part of a loan modification or other arrangement be treated as ordinary income, and taxed as such. These tax laws are frequently changing, so it is generally beneficial for Nevada homeowners who are considering a short sale to consult with an attorney.

Even before any changes to federal debt forgiveness programs, there were certain exemptions, when it came to federal taxes. Homes were required to be a main residence, so rental properties or business properties, for example, were subject to a different set of regulations.

Lenders are required to report any debt cancelations over the amount of $600 to the IRS. Homeowners involved in a short sale should receive forms from their lenders that list how much debt has been forgiven. If these forms are not correct, homeowners should contact the lender for a correction before taxes are filed.

Working with an Attorney During the Short Sale Process

As with any complex real estate transaction, working with an attorney can help homeowners to avoid pitfalls. While some turn to real estate agents, only an attorney may offer legal advice. Short sale attorneys often get involved in the negotiation process and may offer legal counsel along the way. Attorneys can also help and representation if a short sale falls through.

In certain cases, a lender may agree to release a lien in exchange for the proceeds from a short sale but will not release the homeowner from personal liability on the debt. If there is a difference between the mortgage debt and the sale proceeds, this is considered a deficiency and a lender may seek a personal judgment to recover the deficiency. Nevada law is specific about the circumstances in which a deficiency judgment is legally allowed, which is one reason many choose to seek advice from a short sale attorney. Laws surrounding deficiency judgments also vary from state to state, so if a homeowner in Nevada is attempting to negotiate a short sale in a different state, it is important to understand the differences in state law and how this may impact the transaction.

Short sale attorneys also help homeowners to understand the specifics of their short sale agreements. If a homeowner does not fully understand the terms of an agreement, there could be unfortunate surprises upon closing. Even if a short sale is being negotiated, it can potentially fall through, leading a lender to move forward with the foreclosure process. Short sale attorneys will generally provide advice during the foreclosure process as well, if the situation occurs.