Short Sales, the IRS, and the Mortgage Forgiveness Debt Relief Act

Saturday, December 15th, 2012  by attorney Chris Hacker


The response to my last blog posting ranged from relief to outright challenge. And there were a number of responses that people had:

  • Where can I look to see the language for the insolvency exception? (I’ll show you just below)
  • What do you mean it doesn’t matter for most? Why is everyone saying otherwise?
  • But my/my client’s accountant/attorney said….

One of our users replied with the following in an email to us. (I’ve edited out the details about the transaction for privacy purposes.)

We are racing against the clock trying to get approval (which appears likely) for our short sale and close by Dec. 31st because my seller feels certain she will have to pay a huge tax liability on the deficiency. She says her accountant told her she would but this article seems to be indicating the possibility she might not??? …. We are very, very close to getting this accepted except for the time factor. My seller refuses to move forward after Dec. 31st for fear she will owe a tremendous tax debt. Any help you can suggest is GREATLY appreciated!

Another reader pointed out that the Wikipedia entry for the Mortgage Forgiveness Debt Relief Act does not agree with what I’ve written, and asked what we had to say about that.

Well, here it is: anyone that says that there will be NO tax relief for any distressed homeowners if/when the Mortgage Forgiveness Debt Relief Act expires, IS FLAT WRONG.

Prove it? Sure.

  • irs publication 4681

    IRS Publication 4681 – Canceled Debts, Foreclosures, Repossessions, and Abandonments, page 4, 3rd column.


    Here’s the relevant text:

    “Do not include a canceled debt in income to the extent that you were insolvent immediately before the cancellation to the extent that the total of all of your liabilities was more than the FMV of all of your assets immediately before the cancellation….

    Note. This exclusion does not apply …. if the debt is qualified principal residence indebtedness ….unless you elect to apply the insolvency exclusion instead of the qualified principal residence indebtedness exclusion.” (emphasis mine)

    What is the exclusion that Congress created with the Mortgage Forgiveness Debt Relief Act in 2007? The qualified principal residence indebtedness exclusion.

    What exclusion expires on Dec 31? The qualified principal residence indebtedness exclusion.

What exclusion was in place in 2006, before the Act was passed, and will be in place after the Act expires? The insolvency exclusion.

Now, does the insolvency exclusion cover everyone that the qualified principal residence indebtedness exclusion covers? No, it does not. But if it doesn’t cover everyone, why would I say it doesn’t matter for most people doing a short sale? Two reasons:

  1. The first reason is that most people doing a short sale are doing that short sale because they areinsolvent. That’s why their lender is agreeing to the short sale. Because the owner is insolvent.
  2. The second reason covers the rest of the people, the ones who aren’t insolvent, as defined by the IRS. If 80% of owners doing a short sale are insolvent, most of the remaining 20% are doing a short sale because they have to. They are not making a choice between keeping the property and selling it. Keeping the property is not an option for these owners. They are faced with a choice of selling via short sale, giving the property back to the bank via a deed-in-lieu, or losing it via foreclosure. In all three of these outcomes, the lender has a choice: forgive the debt or pursue a judgment if available in that state. If the debt is forgiven, it is reported to the IRS as income to the former owner IN ALL CASES.

That means that our seller above, whose agent wrote to us, and who says she will refuse to go forward after Jan 1 because of the taxes may have been given bad advice. If this seller has the ability to keep the property, then perhaps she should refuse to go forward. But if like most sellers she cannot afford to keep the property, then the short sale should go forward, because even if she’s exposed to taxes, she’s exposed to them with a short sale or a foreclosure.

And, further, with a short sale, the sale will generally result in a higher payoff of the mortgage (which is why the servicers, lenders, and their investors are doing more and more of them). That means that the amount of debt to forgive will be less, which results in less tax exposure.

We’re working on some specific illustrations that you can share with your clients and that they can share with their accountants and attorneys so everyone can be on the same page. Stay tuned…

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Notice: This article is not intended as legal or tax advice for you or your specific situation. If you need tax or legal advice, you should consult your accountant or attorney.


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