Short sale and foreclosure IRS tax implications

Short sales and foreclosures have serious IRS tax implications Virginians should be aware of.  Many people get very worried when they hear that typically, the IRS views forgiven or cancelled debt as taxable income for individuals. In an era where a third to half of all real estate closings are short sales and foreclosures, where banks are in essence forgiving tens of thousands of dollars worth of debt, sellers of these homes want to know: will I have to pay income tax on the shortfall?

The answer is yes unless you meet one of the following four exceptions.

#1) You are in bankruptcy.
#2) You are insolvent according to the IRS. This occurs when your debts exceed your assets. To put it another way, you have negative net worth.
#3) You are dead.
#4) The debt that was forgiven was original purchase money to buy the house or money that can be documented as being put back into the house.

Number four is a recent addition to what used to be just three exceptions. This is the one that helps out many people who bought at the height of the bubble and now for whatever reason have to move or cannot stay in the house. Number four does not, however, help the vast number of people who did cash out refinances or took out home equity lines of credit to pay for things other than home improvements. Many people tapped into the equity of their home to pay off credit card debt, to buy cars, to pay for college for their kids, etc. If the money that was taken out on the home was spent on something other than the home, than the amount that was spent on other things IS taxable income.

There’s no way of avoiding this either. When the debt is forgiven or “cancelled” by the lender, the lender must issue an IRS 1099-C (cancelled debt) form to the borrower. Thus, the IRS is notified of the “income” and it will be up to the individual to file appropriately.


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