Short Sales: The Tax Trap

Whenever I do a short sale closing on the listing side, the first thing I ask is whether or not it is the person’s principal residence. Generally, whenever a lender forgives debt (i.e. does not require repayment), the borrower experiences income for tax purposes. The Internal Revenue Code Section 108 specifically excludes from income discharge of debt for your principal residence, so long as the sale occurred between 2007 and 2012. This Section was enacted to grant relief to struggling taxpayers due to the surge in short sales.         

If the property is investment property, the situation is much more tricky. The discharge of debt is income, for tax purposes. You might be able to offset this income at least partially if the property is a Section 1231 property with a net book value exceeding the sales price. If the property is completely depreciated and the loan exists due to refinance or cash out, then this potential relief might not be available to the borrower.

In that case, you may have placed your client in a worse position. There will be immediate income tax liabilities without capital to pay for it. For listing agents, it may be wise to instruct your clients to speak to a tax advisor or attorney prior to the sale. Avoid ending up in a tax trap.

Donald Hyun Kiolbassa, Attorney at Law, CPA

*Please consult your attorney or tax advisor before relying on this information. Donald Hyun Kiolbassa is not providing legal advice to the readers of this article. These are general rules made in a hypothetical setting.