Be Careful With Short Sales and Loan Modifications

In an effort to avoid a foreclosure on a home, many homeowners look to short sales and loan modifications.  While it is true that short sales and loan modifications can help prevent foreclosures, they can produce nasty surprises come tax time, among other things.

For an example, let’s take a situation where the homeowner has a property worth $200,000, with a loan balance against it of $250,000.  The homeowner is nine months behind on the mortgage payments, and the lender has started foreclosure proceedings.  In an effort to avoid the foreclosure, the homeowner lists the home for sale for $200,000, hoping that the bank will accept those funds and release the lien so that the buyer can obtain clear title to the property.  Luckily, the homeowner finds a prospective buyer, and the bank agrees to accept the $200,000 and release the lien.  The foreclosure is avoided.  So everything is great, right?

Not necessarily.  Depending on the agreement with the lender allowing the short sale, the homeowner may still be on the hook for the remaining $50,000.  The homeowner is then subject to being sued by that lender to collect that money.

Alternatively, the lender may agree to forgive the remaining $50,000 owed, but will submit a Form 1099-C to the Internal Revenue Service reflecting the forgiveness of that debt.  The homeowner may then end up being required to declare $50,000 of the forgiven debt as “income” on that year’s tax return, with the result likely being a rather significant tax bill.   (This issue also arises with debt settlement, as discussed in one of our earlier blog posts.)

The same issue arises with loan modifications.  Using the example above, let’s assume that the lender agrees to restructure the loan by reducing the principal balance to $200,000, and reducing the monthly payments to something more affordable.  Again, this homeowner may be faced with the prospect of having to declare the $50,000 of forgiven debt as income.

Before listing a home for a short sale or agreeing to a loan modification, it is important to consult with a qualified certified public accountant to determine whether or not these actions will result in a huge tax bill.  There are some exceptions to the general rule that forgiven debt is treated as taxable income, most notably the Mortgage Forgiveness Debt Relief Act of 2007, which was recently extended to the end of 2013.  Click here for some important information on the Act.

If it appears that a short sale or loan modification will result in a large tax bill, allowing the home to foreclose and then filing for bankruptcy can be an attractive option.  Most importantly, the discharge of debt in bankruptcy does not result in taxable income to the person whose debt has been discharged.  In addition, if the home is foreclosed on, the homeowner will be eligible to purchase another home under an FHA program after three years have passed, so long as good credit is maintained after the foreclosure, and other requirements are met.

This post is intended to be purely informational in nature, and cannot be considered legal advice.  If you have questions related to short sales, loan modifications, and how they relate to bankruptcy, please call our office at (503) 545-1061 (Oregon cases) or (360) 836-4238 (Washington cases) to schedule a free initial consultation