Tag Archives: Short Sale

Analysis of Discharge of Indebtedness Income vs. taxable debt forgiveness income

Short sales and tax consequences, part 4 of 7

In this post, we will review definitions of Discharge of Indebtedness Income vs. taxable debt forgiveness income. Note that the tax consequences of foreclosure or “short sale” of a commercial or rental property will likely be much different than I will cover in this article. In this series, we are focusing on your primary residence.

You could be facing foreclosure or short sale nearly anywhere in Western Washington. Wherever you live in the state, we can help you to become aware of and informed about the potential tax consequences of a “short sale” or foreclosure.

As discussed before, the $250,000 capital gains exclusion plays a large role in whether you have taxable income on your personal residence post short sale or foreclosure.
Note that this analysis is limited to your personal residence in which you have lived for at least two years. Properties that you received as a gift or inheritance can have a different result as well, so always consult your qualified tax professional in any distress sale situation.

The National Consumer Law Center’s publication “Foreclosure Prevention Counseling”, 2009 edition, available for $60.00 at www.consumerlaw.org, covers these topics in Chapter 9, pages 147-152.

Please note that the Discharge of Indebtedness Income is not necessarily always the same as taxable debt forgiveness income.

What do we mean by “Discharge of Indebtedness Income”? The IRS considers that a taxpayer has income from discharge of indebtedness when a lender forgives some or all of a debt. If the obligation to repay a debt is forgiven, then the government looks to see if that borrowed money now constitutes income to the borrower and, if so, how much. That income is taxable like any other income the homeowner receives. Nevertheless, as described in posts five, six and seven of this blog post series, there are a number of exceptions that may mean that discharge of indebtedness may produce no taxable income at all.

Let’s review three situations in which tax might be due, but rarely result in any taxable income.

First, if there is a foreclosure and the homeowner is not liable for the deficiency, that forgiveness of the deficiency is a discharge of indebtedness income.

Second, another example is a short sale where the house sells for less than the debt and where the lender has agreed to forego any deficiency.

Third, if a loan modification is made in which the lender forgave the principal of the debt or wrote the debt down. The amount of forgiven debt would also be discharge of indebtedness income.

Note that discharge of indebtedness income is very different and distinct from capital gains income. The example that follows below is from an earlier blog post (the third of this seven part series) to help illustrate difference. Please note that it is possible for a short sale to result in both a capital gain and also a discharge of indebtedness situation. Each of (1) capital gains and (2) discharge of indebtedness must be analyzed separately and independently.
Example: A single person completing short sale-illustration of development of capital gain and discharge of indebtedness income

  • $50,000 original purchase price of principal residence many years ago (no funds expended on improvements during ownership so as to increase basis)
  • $210,000 amount on mortgage after many rounds of refinancing to “pull out equity”
  • -$150,000 less: short sale price when homeowner falls into financial distress
  • $60,000 indebtedness not paid due to short sale
  • $100,000 capital gain ($150,000 short sale price – $50,000 acquisition price = $100,000)
  • $60,000 Discharge of Indebtedness Income (but Debtor may not have to pay tax on the $60,000 amount. In later blog posts in this series, we will work through defining and differentiating Discharge of Indebtedness Income vs. taxable debt forgiveness income)
  • $100,000 capital gain. No taxes are due because the capital gains exclusion is $250,000 for a single person on a principal residence.

OK, so our stressed out example short sale debtor above is off the hook for capital gains tax! But will he/she escape income tax on the $60,000 discharge of indebtedness income tax? I will discuss this situation further in future posts on this topic.

Analysis of a Short Sale of a Principal Residence

Short sales and tax consequences, part 3 of 7

In this post, we will review an example of the short sale of a principal residence. In some ensuing posts, I will review the definitions of “discharge of indebtedness income” and also “taxable debt forgiveness income” to follow up on this and earlier posts that discuss foreclosures and short sales. The tax foreclosure or short sale of a commercial or rental property will likely be much different that described in this post.

The $250,000 capital gains exclusion plays a large role in whether you have taxable income on your personal residence post short sale.

Note that this analysis is limited to your personal residence in which you have lived for at least two years. As stated earlier, investment, commercial and rental properties will have a much different result than discussed here-remember to always consult your tax professional. Properties you received as a gift or inheritance can have a different result as well, so always consult your tax professional.

Discharge of Indebtedness Income is not necessarily always the same as taxable debt forgiveness income, according to the NCLC manual “Foreclosure Prevention Counseling”, 2009 edition, on page 149. The National Consumer Law Center’s publication “Foreclosure Prevention Counseling”, 2009 edition, is available for $60.00 at www.consumerlaw.org.

Example: a single person completing a short sale

  • $50,000: original purchase price of principal residence many years ago (no funds expended on improvements during ownership so as to increase basis)
  • $210,000: amount on mortgage after many rounds of refinancing to “pull out equity”
  • -$150,000 less: short sale price when homeowner falls into financial distress
  • $60,000: indebtedness not paid due to short sale
  • $100,000 capital gain: ($150,000 short sale price-$50,000 acquisition price = $100,000)
  • $60,000: Discharge of Indebtedness Income (but Debtor may not have to pay tax on the $60,000 amount. Please read later blog posts in this series as we work through defining and differentiating “Discharge of Indebtedness Income vs. taxable debt forgiveness income)
  • $100,000 capital gain: no tax due, because the capital gain exclusion is $250,000 for a single person on a principal residence.

Please remember that my staff and I are here to help you, regardless of whether you are facing a foreclosure or short sale, anywhere in western Washington state.

Analysis of a Foreclosure Sale

“Short sales” and tax consequences, part 2 of 7

In this post, we will review examples of foreclosure homes and some sample tax impacts of foreclosure.

Regardless of where you are facing a foreclosure or short sale, you must  be aware of potential tax consequences of a short sale or foreclosure.

The $250,000 capital gains exclusion plays a large role in whether you have taxable income on your personal residence post foreclosure.

Note that this analysis is limited to your personal residence in which you have lived for at least two years.

I refer to the National Consumer Law Center’s publication “Foreclosure Prevention Counseling”, 2009 edition, that is available for $60.00 at www.consumerlaw.org, in my analysis. The relevant section is Chapter 9, pages 147-152.

Discharge of Indebtedness Income is not necessarily always the same as taxable debt forgiveness income, according to the NCLC, on page 149.

Here are some “foreclosure” examples of taxable income related to the foreclosure of a principal residence. Note that this analysis would not apply if a home you rented out as a business was foreclosed. That situation is much stickier. You should see your CPA if you have a business or rental property foreclosed.

Example 1: a single person whose residence is foreclosed upon
$50,000: purchase price of home “way back when”
+$10,000: improvements to home like a new deck and changed shower to bathtub
$60,000: basis in home
The home was refinanced many times to “pull out” equity, so the debt against the home at the time of foreclosure was $325,000.
In addition, $5,000 in “cash for keys” was paid to the single person owner after foreclosure as an incentive to move out without damaging the property.
At the time of foreclosure, the house was appraised at $400,000 by the bank.
$60,000: basis (home purchase price plus $10k improvement)
$330,000: “sale” price (e.g. amount of debt $325k + $5k paid “cash for keys”
$270,000: capital gain ($330k-$60k = $270k)
$250,000: capital gain exclusion
$20,000: capital gain
$3,000: capital gain tax due ($20k x .15 = $3k tax due)

Note: in later posts in this blog, one of five exclusions to the obligation to pay $3,000 in capital gains tax may come into play
Example 2: a single person whose residence is foreclosed upon
$125,000: home acquisition price, no improvements made to increase basis
$132,000: debt owed on home at time of foreclosure, including foreclosure fees
$80,000: home fair market value at time of foreclosure as housing prices have collapsed
$45,000: capital loss-capital losses are not taxable, thus homeowner does not owe any tax due to foreclosure as a capital tax.
However, in this example, the single person foreclosed upon could potentially owe income tax (as no capital gain tax) as discharge of indebtedness income/taxable debt forgiveness income. More on this later.
In the succeeding blog posts in this seven part series, I will cover and explain how discharge of indebtedness income can result in taxable debt forgiveness income. I will also discuss the five exceptions/exclusions to tax on the income.

Remember, we are here to help you, regardless of where you are facing a foreclosure or short sale. If you need help, please contact us.

Short sales and tax consequences – analysis of a “normal” sale

Regardless of where you live in Washington state—whether you call Federal Way, Bremerton, Tacoma, Renton, Auburn, Tukwila,  Lakewood, University Place, Puyallup, or Olympia home—you must be aware of potential tax consequences of a “short sale” or foreclosure.

The $250,000 capital gains exclusion plays a large role in whether or not you will have taxable income on your personal residence after foreclosure.

Please note that this analysis is limited to your personal residence in which you have lived for at least two years.

The NCLC (National Consumer Law Center) publication entitled “Foreclosure Prevention Counseling”, 2009 edition, Chapter 9, pages 147-152, covers this subject well. This publication is available for $60.00 at www.consumerlaw.org.

For example, Discharge of Indebtedness Income is not necessarily always the same as taxable debt forgiveness income, according to the NCLC, page 149.

To understand the problem of Discharge of Indebtedness Income/taxable debt forgiveness income, let’s examine a normal (non distress) transaction to determine whether the transaction does or does not result in taxable income.

Example #1 from the NCLC:

$100,000 purchase price of home
+ $30,000 add: improvements (new deck, addition, etc.)
= $130,000 new basis

$160,000 sale price
– $9,000 less: sales expenses
= $151,000 net sale price

$21,000 capital gain
$250,000 capital gain exclusion

$0 taxable gain
$0 taxable gain tax to be paid

Example #2 – single homeowner

$20,000 purchase price
+ $30,000 certain improvements
= $50,000 new basis

$600,000 sale price
– $40,000 less: sales expenses
= $560,000 net sales price

$510,000 capital gain ($560,000 – $50,000 = $510,000)
– $250,000 capital gain exclusion
= $260,000 taxable gain

$39,000 capital gains tax payable $260k x .15 tax rate = $39,000; assuming 15% tax rate on long-term capital gain)

The previous examples contemplate a “normal” sale–not a short sale or foreclosure.

In a future post, I will provide some examples of foreclosure/short sale operation.

Seattle home sales drop 32% – worst October since record-keeping started in 1994 – “shadow inventory” of 2 million homes

Nationally, 26% drop in sales of existing homes for October 2010. This was reported to have been the worst October in at least twenty years, according to the NY Times’ David Streitfeld (NY Times, Wednesday, November 24, 2010)

Portland, OR home sales droped 39%, Minneapolis saw a 41% drop and Massachussets and Illinois saw drops of 28% and 34%.

According to Mr. Streitfeld, aout 4.43 million homes were sold on a seasonally adjusted annual basis in October 2010, compared with nearly 6 million in October 2009. In October 2008, at the height of the financial crisis, about 5 million homes were sold. Distressed sales, including foreclosures, have ben about a third o the market, while first-time buyers ahve ben as much as 50 percent. Both are high by historic levels, reports Mr. Streitfeld.

Mr. Streitfeld reports taht short sales, where the sellers negotiate with their lender to sell thier house and repay less than the full amount owed, are rising in popularity although they are still outnumbered by foreclosures. Bank of America, for instance, said it had agreed to more than 60,000 short sales this year.

It appears to Mr. Streitfeld that the slight drop off in foreclosures is in turn increasing the likelihood of a successful "short sale" – he reports that lenders see themselves under pressure from shoddy documentation procedures, so with all 50 state attorneys general investigating foreclosure procedures, the banks have de-emphasized foreclosrues and have emphasized short sales.

Mr. Streitfeld also notes that there still remains a large "shadow inventory" of more than two million delinquent and foreclosed homes that banks will ultimately have to bring to the market in order to dispose of the homes. For this reason, the sales of previously foreclosed houses has dropped. By way of example, in California, there were 19,925 foreclosed homes sold by the banks in October 2008, and that number had dropped to 15,621 in October 2009, and then down to 10,367 in October 2010.

http://www.nytimes.com/2010/11/24/business/economy/24foreclosure.html

Buying a spanking new home or a recently built used home in a housing development? CAUTION! Beware of developer 99 year “resale fees” hidden in the covenants.

The NY Times reported on September 12, 2010 that "re-sale" fees creeping into the fine print development covenants, as reported by Janet Morrissey. See Business Section 9/12/10, front page NY Times.

A WHAT????

A "re-sale fee" is a 1.0% fee that must be paid to the developer for 99 years at any time the home changes hands after the original sale to homeowner #1. They are terms that are now being quietly and sneakily drafted into the Homeowners’ Association covenants and/or sales contracts all over America.

Ms. Morrissey reports that "A growing number of developers and builders have been quietly slipping "re-sale fee" covenants into sales agreements of newly built homes in some subdivisions. In one case detailed by Ms. Morrissey concerning a family of seven (five children) who purchased in Utah, the "re-sale fee" language was ina aseparate 13-page document – called the declaration of covenants, conditions and restrictions – that wasn’t even included in the closing papers and did not require a signature by the buyers.

Sometimes the "re-sale fee" is labeled in a difficult to understand nomenclature and is then called a "capital recovery fee" or a private transfer fee".

Ms. Morrissey presents the scenario: "Someone selling a home for $500,000, for example, would have to pay the original developer $5,000. If the home sold again two years later for $750,000, the second seller would have to pony up $7,500 to the developer, and so on." Even if a home declines in value, the seller still must pay the 1.0% fee to the original developer, even years and years later.

Ms. Morrissey reports that the Federal Housing Finance Agency (FHA) is considering a proposal to prohibit the transfer fees on all mortgages financed by Fannie Mae, Freddie Mac and the Federal Home Loan Banks. 17 states have already placed limitations or bans on such "re-sale fees". However, even should such practices be eventually curtailed by a rule or law, the rule/law is unlikely to apply retroactively to older "re-sale fee" terms.

As a lawyer, I would comment wrly how ironic it is that it is often so difficult for homeowner #2 or #3 to sue a builder/developer for shoddy construction and defects in the home, yet that same shoddy contractor/developer may be able to reap rewards for 99 years from each and every homeowner that comes to own and sell the shoddily constructed residence.

See link to NY Times article: http://www.nytimes.com/2010/09/12/business/12fees.html?_r=1&scp=1&sq=developers&st=nyt

IDEAS FOR ACTION: Whenever you purchase a home: (1) secure a written acknowledgement and written representations from the selling homeowner that there is no such "re-sale fee" tassociated with the residence or condominium. (2) ensure that you closely review the "exceptions page" of the title insurance policy and all of the homeowners’ association covenants to carefully look for such "re-sale fee" language. or documents. I(3) if you are going to be the 3rd, homeowner, ask the 2nd homeowner (from whom you are purchasing) to produce a copy of the settlement statement from the prior transaction between 1st homeonwer and 2nd homeowner which should disclose any such fee paid to a developer. (4) ensure that you obtain a written representation from the seller that you have been provided with a copy of any and all documents which govern and affect your purchase, use, enjoyment, future/ongoing fees to be paid with respect to the parcel and sale of the parcel.

Zillow.com chief economist and Yale Professor of Economics both say: “HOMES ARE NO LONGER GOOD NEST EGG INVESTMENTS” in Tacoma, Renton, Olympia, Bremerton and Chehalis.

“People [wrongly] think it’s a law of nature [that housing prices always go up so as to always beat inflation]” says Yale University economics professor Robert J. Shiller and economist Karl E. Case. Interviewed by the New York Times, Yale economist Mr. Shiller relates that there has been an overall “bubble” since the end of World War II that is unlikely to be repeated, but that even during that historically unprecedented 60 year post WWII boom, that housing values outpaced inflation by only 1.1% per year. Quite to the contrary of the 1947-2005 point of view, during the 1900-1946 time period people saw houses quite differently. They saw them like they were cars. Houses 1900-1946 were seen as a consumer durable that the buyer eventually used up says Yale economist Shiller.

According to Yale University economist Shiller, the first notion of housing as an investment first began to blossom after WWII, when the nesting urges of returning soldiers created a construction boom. Demand was then further stoked as the “baby boom” of post WWII babies grew up and bought places of their own in the 1970s.

Adding fuel to the post WWII housing boom, (1) the inflation of the 1970s (which increased the value of hard assets) and (2) liberal tax policies (like deductible mortgage interest and property taxes AND lack of significant capital gains on housing appreciation) both helped make housing a good bet to at least slightly beat inflation.

Nevertheless, Yale’s economist Shiller says that despite all of these accelerating economic “tailwinds” prices rose moderately for much of the period, providing a mere 1.1% annual increase in value after inflation. However, during the extraordinary housing bubble that began in the late 1990s, housing prices were beating inflation by an average of 4.0% per year.

Zillow.com chief economist Stan Humphries echos Mr. Shiller, saying housing prices will be lucky to beat inflation, as quoted in the New York Times on August 23, 2010: “There is no iron law that real estate must appreciate…all those theories advanced during the boom about why housing is special – that more people are choosing to spend more on housing, that more people are moving to the coasts, that we are running out of usable land – didn’t hold up.”

I urge all of my customers in Tacoma, Renton, Olympia, Bremerton, Chehalis, and throughout Washington state to please read David Streitfeld’s front page article in the Monday, August 23, 2010 New York Times , which provided the content for this blog post.