Short Sale vs. Foreclosure


Of course both short sale and foreclosure are not appealing to my senses and I detest equally both of them, but here my likings are not in discussion: I have to make distinction between these two often quoted and touted remedies in this national crisis. It is actually a selection between the two lesser evils.

Short-Sale versus Foreclosure. A short sale is just the opposite of a full sale. Let us say your home has an appraised value of $400,000, and you had placed your house on sale for quite some, and no offer comes, and endlessly waiting you get tired. You can tell the bank that heck with it, I want to just get out of it. The bank would plan along with your knowledgeable broker a sale which should be quick, non cumbersome and in which you would not see a penny coming to your pockets. Altogether it is called a Short Sale. It is not as damaging on your credit report as let us say a foreclosure is. Closely related to short sale, of course, a surrender of deed which I will discuss in another time. The lasting impact of a short sale would stay few years on your credit. You may have to report to IRS which is a tax question and need to be addressed to your tax consultants.

Few things you have to remember.
1. Banks would not allow a short sale if there is a second lien attached with it. A short sale is a compromise between you and the bank who is the lien holder of your first principal. A short sale would wipe out the junior interests and that means second lien holder or HELOC. They would not get anything, and they would not agree to short sale unless they get something out of it. Now there would be a fight between the first lien holder and the second lien holder. This fight of course is detrimental to your interest and can cause delay in the process. Also, there are many layers of approvals on various levels in the banks’ hierarchy and oligarchy.

2. You can compromise with the bank how it should be reported to you credit bureaus. Use it to your advantage.

3. A negotiated short sale would stop the bank for a deficiency judgement against you.

4. One problem, if there is a short sale and you declare bankruptcy right after it, it can be treated as a collusive transaction between you and the lender, and your other creditors can contest it and may invalidate it.

5. Of course the solution again lies with your knowledgeable attorney handling your issue.

6. The IRS has very complex tax consequences in a debt renegotiation, such as a short sale, or foreclosure, that are more detrimental for solvent taxpayers than those who are insolvent or bankrupt as each generates Cancellation of Debt Income.

7. A borrower who refinanced their home to take the cash out to buy another home, then let the first home go to foreclosure thinking they are getting off debt and obligation free, are living in a fool’s paradise. This practice can be stopped by the lender.

The first thing to establish is what the home’s basis is. The IRS definition for basis is your investment in the home for tax purposes. It usually starts with the cost to acquire the house. Adjusted basis is the increase or decrease in the original basis according to certain events. Increases to basis include but are not limited to improvements having a useful life of more than a year, assessments for local improvements, sales tax, the cost of extending utility lines to the home, legal fees such as the cost of defending or perfecting title, and zoning costs. Decreases to basis include but are not limited to depreciation, nontaxable corporate distributions, casualty and theft losses, easements, and rebates from the seller.

IRS Pub 551 Basis of Assets is a handy reference. Taxable gain or loss on a house is determined by the difference of the selling price/amount realized and its adjusted basis.

IRC 61(a)(12) CODI, Cancellation of Debt Income other than as a gift, creates taxable income to the debtor unless an exception applies. In a Short Sale, the lender issues a 1099-C to the IRS. In a Short Sale example of a home, whether it be primary, second home, or third home, A bought his home in Reno in November 2004 for $290,000. In November 2005, A refinanced to a new loan for $380,000. Unfortunately, today its Fair Market Value is $260,000. A can no longer make the payments due to his legal split with B, his spousal equivalent. In 2007 A sells the property through a Realtor who successfully negotiated a Short Sale of $120,000 loan reduction with A’s lender, so A walked away with no immediate out-of pocket loss. A has a $120,000 nondeductible loss (adjustment to basis) on his home. The $120,000 principal reduction is taxable income in 2007 to A. (rev. Rul. 82-202) It is reported as “Other Income” on Line 21 of the 1040. If A had bought with seller-financing, there is special rule IRC 108 (e) (5). If three conditions are met, the borrower reduces the property’s basis and does not recognize CODI.

The IRS treats a foreclosure as a sale or exchange from which the borrower may realize gain or loss. In a foreclosure, the lender issues a 1099-A to the IRS. In a recourse state such as Nevada, the lender checks Box 5 as “Yes.” The borrower is personally liable to pay any amount of the debt not covered by the property’s value. The amount realized for borrower’s Federal gain or loss on the transaction is the smaller of debt cancelled or FMV of the transferred property. The borrower’s CODI is ordinary income if the loan balance exceeds the property’s FMV. If A had gone to foreclosure, his adjusted basis is $290,000, the recourse debt cancelled is $380,000 and the FMV of the property is $260,000. Here he realizes $260,000. The cancelled debt ($380,000) up to the property’s FMV ($260,000). Compare amount ($260,000) realized with adjusted basis ($290,000). A has a $30,000 non-deductible loss. He also recognizes ordinary income equal to the CODI of $120,000 ($380,000 debt cancelled less $260,000 FMV). This $120,000 is the part of the cancelled debt not included in the amount realized.

In a short sale example of a rental house, if A had bought and used the house as a rental, if A is not insolvent or bankrupt, if A can meet the required extent of his involvement, A can elect on Form 982 to exclude from gross income any income from the discharge of QRPBD (Qualified Real Property Business Debt). IRC 108(c)(3) QRPBD includes debt 1) that was incurred or assumed in connection with real property used in trade or business and that is secured by such real property, 2) debt incurred or assumed to acquire, construct, reconstruct, or substantially improve real property used in a trade or business. IRC 108(c)(1) Income excluded for the discharge of QRPBD reduces the basis of the taxpayers depreciable real property, first to the property with the discharged debt, then to the taxpayer’s other depreciable real property proportionally, on each property’s relative adjusted basis

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