Residential Short Sales--Time Is Running Out

It's time to readdress the issue of "short sales" as the temporary tax relief provided to homeowners is about to expire.

A "short sale" of real property occurs when the owner sells the property for less than the outstanding indebtedness secured by that real property.  Because the foreclosure process is costly and has been moving at a snail's pace, lenders have sometimes accepted a deed in lieu of foreclosure from the property owner and written off any deficiency balance.

Typically under US tax laws, when indebtedness is forgiven, the amount of forgiven indebtedness is is taxable as income to the debtor.  Taxable income that doesn't result in actual cash in your pocket is often referred to as "phantom income."  For short sales or deeds-in-lieu where the lender has agreed to write off the deficiency balance owed under the loan, debtors would receive a 1099 for the balance amount forgiven and would have to disclose this phantom income on their tax return.  For owners of commercial real property, this continues to be the case.

However, in 2007, as a direct result of the meltdown in the mortgage market and the epidemic of pending foreclosures on residential properties that were now worth less than the outstanding balance on the mortgages, Congress passed the Mortgage Forgiveness Debt Relief Act. The result of this law was to relieve homeowners of the taxable income problem that resulted from the short sales and deeds-in-lieu.

This tax break expired at the end of 2012 but was renewed for one year and now expires on December 31, 2013. While it is possible Congress will further extend the tax break for homeowners another year or longer, there is no guaranty.

If you are a homeowner and hope to complete a short sale on your home, time is running out if you want to close before year end and avoid paying ordinary tax rates on phantom income. 
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