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Credit Consequences of a Short Sale
The Credit Consequences of a Short Sale and the credit consequences of a foreclosure vary. The general consensus is that an Arizona Short Sale will show up on your credit report as a "settlement", "settlement for less than owed" or a "pre-foreclosure in redemption". Since some lenders will not consider allowing an Arizona Short Sale until a few payments have actually been missed you may also have a few "lates" on your credit report. Neither of these is a good thing to have but it’s possible to recover within two years or less. Now we have asked many credit experts and in general, an Arizona Short Sale can drop your credit score by 100 points. Most experts vary on the exact amount it will affect your credit. Expect that your credit will be affected during this process. Consider enrolling yourself into a credit repair program after the Short Sale is complete.
A foreclosure on your credit report can take 7-10 years to remove and can cost your credit rating (FICO) up to 200-280 points which is a very big hit. So, if you have no better alternatives pursue a short sale aggressively and avoid foreclosure.
Tax Consequences Of A Short Sale
Many homeowners are unaware that when completing an Arizona Short Sale, possible short sale tax issues can arise. As such, an owner considering an Arizona Short Sale should absolutely discuss these possible issues with an attorney, accountant, or other appropriate professional. From our understanding, the debt forgiven by a lender is generally taxable to the borrower as "debt discharge income." When a taxpayer receives proceeds from a new loan, those proceeds are not taxable income because there is an offsetting obligation to repay. However, if the debt is cancelled, there may be debt discharge income. This basically means that if you owe $200,000 and short sale the home for $150,000, on your next tax return it could look like you have $50,000 worth of earned income from the sale of your residence and would be treated as taxable income. If your lender chooses to, they could send you an IRS Form 1099-C: Cancellation of Debt at the end of the year. What are the odds that you have extra tax money lying around after you just went through an Arizona short sale on your home?
The Mortgage Forgiveness Debt Relief Act of 2007 would eliminate the tax owed on any forgiven mortgage debt. This bill has been passed and signed into law by the president! The bill permanently eliminates tax on up to $2 million of debt for a principal residence. This bill protects primary residence homeowners only (not investors), and the best part about this bill is that it is retroactive to January 1st, 2007. This means that any Arizona short sale conducted after that date automatically is protected from any tax implications! It is set to end December 31, 2009. For more info, please visit
http://www.whitehouse.gov/news/releases/2007/12/20071220-6.html
IRS FORM 982
If you are not protected under the new Mortgage Forgiveness Debt Relief Act of 2007, you still have a way around the tax consequences of an Arizona Short Sale. If you receive a 1099-C from a creditor, you must report the amount of the canceled debt as income to the IRS even though you did not actually receive any money (phantom income). (The amount shown in Box 2 of the 1099-C form is the amount that must be reported!) However, the IRS recognizes “Insolvency” as a situation where cancelled debt might not have to be reported as income. Insolvency is basically your total debts exceed your total assets at the time your debt was settled or deemed non-collectable.
If you are “insolvent”, you need to explain this to the IRS in one of two ways. 1) By filling out IRS Form 982: Reduction of Tax Attributes Due to Discharge of Indebtedness (http://www.irs.gov/pub/irs-pdf/f982.pdf) or 2) Attaching a detailed letter to your tax return explaining the calculation of your total debts and assets.
You accountant can help qualify your insolvency and help you fill out any IRS Forms! Here are some helpful questions that you will need to ask you tax professional:
- Can I avoid paying taxes on the forgiven debt if I was insolvent at the time of the short sale?
- Do I have to file bankruptcy to be considered insolvent?
- If you already went through a short sale and paid taxes can you file an amended return and get a refund?
- Does a IRS Form 982 have to be filed in order to be eligible for tax relief?
- Am I protected under the Mortgage Forgiveness Debt Relief Act Of 2007?
Let’s Recap:
The Bank accepts an Arizona Short Sale, your foreclosure is canceled, and you sell your home for less than what you originally owed. The new House Bill H.R. 1876 should protect you from federal taxes, but if you do not qualify, and you receive a 1099-C: Cancellation of Debt at the end of the year, you still have options! Ask your accountant about the IRS Form 982: Reduction of Tax Attributes Due to Discharge of Indebtedness (http://www.irs.gov/pub/irs-pdf/f982.pdf). If you can prove your insolvency (your expenses outweigh your income) then you should qualify for an exemption and not be taxed on the deficiency.
Lucy Stephens, REALTOR®
Certified Negotiation Expert (CNE)
Master Short Sale Consultant (MSSC)
Direct 623-695-9189 Fax 866-200-1411
Lucy@RealShortSaleSolutions.com
