Capital Gains

The Tax Consequences of Short Sales and Foreclosures: Principal Residences

By Glenn Schanel, CPA, CFP®

(This article is the first in a three part series on the tax consequences of a short sale or foreclosure. This installment will cover properties that qualify as a principal residence.)

The last thing a person involved in a foreclosure or short sale needs is a crushing tax bill, so it is important to understand and be aware of potential tax consequences. When it comes to a qualified principal residence, taxes can be avoided in most, but not all, circumstances.

A principal residence for tax purposes is a home that a taxpayer has owned and lived in for at least two of the past five years. Keeping that definition in mind, we will consider both the capital gains tax and the tax on debt forgiveness income that could result from a short sale or foreclosure.

Tax on Capital Gains

The gain/loss on a short-sale or foreclosure transaction is calculated as the market price or sale price minus the taxpayer’s cost basis. In the event there is a loss, there is nothing to report for tax purposes, because a loss on a principal residence or any personal property is not deductible. If there is a gain on the residence, then the taxpayer is eligible to exclude up to $250K (or up to $500K for a married couple that files married filing jointly) of this gain.

Therefore, when it comes to a foreclosure or short sale on a principal residence, unless the capital gain exceeds the exclusion maximums, there will be no capital gains tax.

Debt Forgiveness Income

Debt forgiveness income is the difference between the loan amount at the time of the foreclosure or short-sale and the market price or sale price. As a general rule, debt forgiveness income is taxable, but there are some exceptions.

The Mortgage Forgiveness Relief Act of 2008 says that debt forgiveness income can be excluded if the debt can be considered “Qualified Principal Residence Indebtedness” (QPRI). QPRI is any debt that is secured by a principal residence and was incurred to acquire, construct or improve a principal residence.

Therefore, a potential income recognition problem does exist if a taxpayer had refinanced and used any “cash-out” proceeds for some purpose other than home improvement. In that case, the income would be taxable unless the taxpayer qualifies for an exclusion under the bankruptcy or insolvency exceptions.

Consult with a Tax Professional

This can be a complicated issue, so we recommend that anyone involved in one of these transactions consult with a tax professional to review their particular situation. If you or someone you know is involved in a foreclosure or a short sale and is concerned about the possible tax consequences, please feel free to contact our offices at (561) 624-2118 to schedule a consultation.

Glenn Schanel, CPA, CFP® is the President of Schanel & Associates, PA, Certified Public Accountants. The firm provides tax, accounting, and consulting services to clients throughout South Florida and the United States.

The information contained in this communication is intended as general guidance on matters of interest only. The application and impact of laws can vary widely based on specific facts involved. Given the changing nature of laws, rules and regulations, and the inherent hazards of electronic communication, there may be delays, omissions, or inaccuracies in information contained in this transmission. The information contained herein should not be used as a substitute for consultation with professional accounting, tax, legal or other competent advisors. Pursuant to Regulations Governing Practice Before the Internal Revenue Service, any tax advice contained in this communication, unless explicitly provided otherwise, is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.