Short Sale

Short Sale Information for underwater Homeowners

source: irs.gov

A short sale occurs when you agree to sell property you do not own (or own but do not wish to sell). You make this type of sale in two steps.

  • You sell short. You borrow property and deliver it to a buyer.
  • You close the sale. At a later date, you either buy substantially identical property and deliver it to the lender or make delivery out of property you held at the time of the sale. Delivery of property borrowed from another lender does not satisfy thisrequirement.

You do not realize gain or loss until delivery of property to close the short sale. You will have a capital gain or loss if the property used to close the short sale is a capital asset.

The Instructions for Form 1099-B discuss when you should receive a Form 1099-B for short sales. For more information, see the Instructions for Form 1099-B.

Reporting a short sale.   Report any short sale on Form 8949 in the year it closes. If a short sale closed in 2014 but you did not get a Form 1099-B for it because you entered into it before 2011, report it on a Form 8949 in Part I or Part II (whichever applies). In column (a), enter (for example) “100 sh. XYZ Co. — 2010 short sale closed.” Fill in the other columns according to their instructions. Report the short sale the same way if you received a 2014 Form 1099-B that does not show proceeds (sales price).
Exception if property becomes worthless.   A different rule applies if the property sold short becomes substantially worthless. In that case, you must recognize gain as if the short sale were closed when the property became substantially worthless.
Exception for constructive sales.   Entering into a short sale may cause you to be treated as having made a constructive sale of property. In that case, you will have to recognize gain on the date of the constructive sale. For details, read about Constructive Sales of Appreciated Financial Positions on irs.gov website.
Example.

On May 7, 2014, you bought 100 shares of Baker Corporation stock fForeclosure _newspaper_wordleor $1,000. On September 10, 2014, you sold short 100 shares of similar Baker stock for $1,600. You made no other transactions involving Baker stock for the rest of 2014 and the first 30 days of 2015. Your short sale is treated as a constructive sale of an appreciated financial position because a sale of your Baker stock on the date of the short sale would have resulted in a gain. You recognize a $600 short-term capital gain from the constructive sale and your new holding period in the Baker stock begins on September 10.

The Mortgage Forgiveness Debt Relief Act and Debt Cancellation Extended

On December 16, 2014, President Obama signed a bill which extended the 2007 Mortgage Debt Relief Act through December 31, 2014.  The mortgage Debt Relief Act provides tax relief to individuals who have had mortgage debt forgiven as a result of short sale, principal reductions or foreclosure sales.  The last extension to the Debt Relief Act expired December 31, 2013 leaving many facing serious tax consequences as a result of short sales or foreclosure sales.  With this extension, tax consequences resulting from short sales, foreclosures and other forms of mortgage debt cancellation that closed prior to December 31, 2014, may be eligible for relief under the Act (for more information on eligibility see: http://www.irs.gov/Individuals/The-Mortgage-Forgiveness-Debt-Relief-Act-and-Debt-Cancellation-).  In typical fashion, Congress left the decision to further extend the Act to 2015, or beyond, to the new Congress.

Insolvency Clause Tax-Saving Alternative to Mortgage Forgiveness Debt Relief Act in 2015

If you are underwater on your home mortgage and need to sell your house, what do you do now?

IRS “Insolvency Clause” Offers Tax-Saving Alternative

Short sale sellers can still be exempt from tax liability under the “insolvency clause” of the Internal Revenue Code. The clause states that a seller is exempt from paying tax on any forgiven debt to the extent that they are insolvent. In other words, if the seller’s debts and liabilities exceed their assets by more than the amount of debt forgiven, they do not have to pay taxes on the forgiven debt.

Here’s an example of how the Insolvency Clause works:

A seller has a home valued at $300,000, but the mortgage debt is $400,000. We short sell the property for $300K and the bank elects to forgive the debt on the $100,000 shortfall amount. Since debt that has been forgiven counts as taxable income, the IRS would treat the $100,000 of forgiven debt as income.

MORTGAGE DEBT $400,000
SALE PRICE [-$300,000]
FORGIVEN DEBT(Taxable income) $100,000

This is where the insolvency clause formula comes in. Begin by adding up all of your debts/liabilities in one column and all of your assets in another. For this formula, the IRS wants you to include the mortgage debt as a liability, and the fair market value of your house as an asset. Let’s say you have $600,000 in assets and $700,000 in debts/liabilities. You are insolvent by $100,000.

ASSETS $600,000
LIABILITIES [-$700,000]
INSOLVENCY [$100,000]

Since your insolvency amount of $100,000 equals the forgiven debt amount of $100,000, it’s a wash and you will not have to pay taxes on that forgiven debt. You are shielded dollar-for-dollar on the amount of forgiven debt up to your insolvency number. Let’s say you were only insolvent by $80,000. In that case, you would still have to pay income tax on the remaining $20,000 of forgiven debt.

INSOLVENCY [$100,000]
FORGIVEN DEBT [-$100,000]
TAXABLE INCOME -0-

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