An increasing number of homeowners are turning to short sales in order to unload their homes without going through a foreclosure.
If you decide that a short sale is right for your situation, it's important to understand that you will need to complete the transaction before the end of the year if you want to avoid running into tax problems that can weigh on your finances.
What is a Short Sale?
A short sale is a real estate transaction in which the mortgage lender agrees to accept less than you owe on the home in the name of selling the house. If you owe $200,000 on your mortgage, but home values have dropped in your neighborhood so that you can only get $180,000 for the home, a lender might be willing to allow you to sell the home “short” of what you owe. Short sales also come into play when you are having problems staying current with your mortgage payments.
A short sale can help you avoid a foreclosure. This means less hassle for the lender in many cases, and the lender might get more with your short sale than with an attempt to sell a real estate owned property.
You are forgiven the difference between what you owe and what the home sells for. In this instance, you are forgiven $20,000.
“Wait… this sounds too good to be true!”
There are a few other things you need to know about the short sale process, especially for this year:
Tax Implications of Debt Forgiveness
One of the the important things you have to realize about any sort of debt forgiveness is that the amount is usually considered income. No, you didn't receive a cash payment. However, since you borrowed the money from someone else, and the spent it, and you aren't being required to repay the money, it is seen as income. You did get the money at some point — and you did have use of it.
Since debt forgiveness amounts are considered income, they are taxed as such. So, if you are forgiven a $20,000 debt, your income for that year will be $20,000 higher, and you will be taxed on the amount, even though you don't have the cash in hand.
The exception to this debt forgiveness rule for the last few years has been mortgage debt.
Mortgage Forgiveness Debt Relief Act Ends with 2013
Toward the end of 2007, when the implications of a possible mortgage market crisis were being felt the Mortgage Forgiveness Debt Relief Act was passed. Mortgage rates were dropping, but no one could refinance out of their homes due to having no equity. This was resulting in a lot of short sales and foreclosures. The Act was designed to temporarily exempt mortgage debt forgiveness from being taxed.
The Act was extended a couple of times. Most recently, the Act has been extended to last until December 21, 2013. This means that, if you have any mortgage debt forgiven you during this year, you can avoid paying taxes on the amount.
As things stand right now, though, once 2013 comes to an end, you will be back to pay taxes on forgiven mortgage debt. This can make a big difference. Adding $20,000 to your income is a big deal — and can even bump you up a tax bracket. Because mortgage debt forgiveness tends to deal with much larger amounts than other types of debt forgiveness, it has a bigger impact on your bottom line, and can be even more devastating at tax time.
What You Can Do
If you are trying to sell your underwater home and struggling, now is a good time to begin exploring a short sale. Realize that many lenders require your home to be on the market for at least 90 days at a price that would pay off the mortgage before they'll even consider authorizing a short sale.
You also need to demonstrate that you are having trouble making the mortgage payments, whether it's because you lost your job, or because you are moving to another city and you will have difficulty making both payments.
Completing a short sale can be a long process, so it's not something you want to attempt one or two months before the end of the year. Instead, you want to start making the arrangements for it as soon as possible so you can have the process completed before the end of the year to ensure that your tax break is safe.
Remember that a short sale can affect your credit, and impact your ability to buy a home in the next year or two. The damage can be similar to declaring bankruptcy. Thankfully the damage to your credit from a short sale is repairable just like you can repair credit after bankruptcy. Consider all your options, and understand the consequences, before you decide to go through with a short sale.