Travis H. Long, CPA, Inc. Blog

Originally published in the Pacific Grove Hometown Bulletin

May 16, 2012

If you think you may not be able or willing to hold on to your home for the long-term, you should seriously consider your options for short sale or foreclosure as soon as possible.  At the end of this year, Internal Revenue Code Section 108(a)(1)(E) is set to expire (California tax law conforms to the expiration also).  This is the provision that allows people to possibly exclude from income, cancelled debt when recourse loans on their primary residence are higher than the value of the home.  These transactions take three to 12 months to complete, so time is of the essence.

Between foreclosures and short sales, short sales are your best option in this regard.  This is where you find a buyer and the lender accepts the buyer’s offer, even though it is less than what you owe the lender.  Current law in California forces lenders to cancel the remaining debt as of the date of the short sale and prohibits them from pursuing your personal assets if they agree to the short sale.  A foreclosure does not guarantee the lender will not pursue you for the remaining debt.  Even if they do decide to cancel the debt, it may not be until after the end of this year.

Whether debt is cancelled by short sale or possibly by foreclosure, the cancelled debt is potentially taxable income to you.  If you did not take cash out during past refinances, or to the extent you put cash-out back into improving the property, you will likely be able to exclude the cancelled debt income from your taxable income due to code section 108(a)(1)(E)…until the end of this year.  After that, you will likely only be able to exclude the debt if, and only to the extent you are insolvent (more liabilities than assets).  Bankruptcy is another option, but it must be filed before you lose the property – in other words, plan early.

Imagine $200,000 of income on your tax returns from cancelled debt, generating an extra $75,000 or more of tax.  Many people will find these transactions to be the largest potentially taxable transactions in their life, so it is important to seek competent professional advice, plan appropriately, and avoid the tax if at all possible.

Prior articles relating to foreclosures and short sales are republished on my website at www.tlongcpa.com/blog.

IRS Circular 230 Notice: To the extent this article concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law.

Travis H. Long, CPA is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.