Many sellers have lost jobs, have health issues or might be relocating to a different area due to a job transfer. So they’re already behind the proverbial eight-ball when the house goes on the market.
Lender’s Shortage is Seller’s Income
The IRS says that a canceled debt is considered income to the person whose debt was canceled. In other words, if a seller sells for $100,000 but owes $150,000, the bank would issue a 1099 to the seller for the $50,000 that the bank never received. Makes sense – the seller got the benefit of the $50,000 that never got paid.
But what about all those sellers who already are in trouble financially? Take someone who makes $40,000 a year and suddenly give them a 1099 that says they’ve made an additional $50,000 – plus make them pay income tax on that additional $50,000 and you have a real problem.
Congress to the Rescue
The number of sellers facing hardship due to that taxable income was large enough, that in 2007, Congress passed the Mortgage Forgiveness Debt Relief Act. The Act allows sellers to avoid paying income tax on that additional income. The Act is in effect through 2012.
Which brings me to a very big issue – make sure your tax preparer knows about this!
A seller I’m working with just had her short sale approved by the bank. We go to settlement in about 10 days. She cried tears of joy at finally having this financial burden lifted.
Until she talked to the guy who prepares her taxes. She told him she would get a 1099 for the amount forgiven by the bank and he told her how much she would owe both the IRS and the State in taxes.
She called me, again almost in tears, because it would take her years to pay off the IRS.
I reminded her of the Act – sent her links from the IRS on the topic – and strongly recommended she get a second opinion. She did and she is much happier now.
My feeling is – when you have a one-time event like a short sale settlement, it’s worth spending a few minutes with Google or in getting second opinions. I am really amazed that someone who prepares taxes wouldn’t know about this Act – it’s a pretty big deal in a housing market where short sales aren’t unusual.
© 2011 Susan Pruden