The Tax Consequences of Short Sales and Foreclosures: Principal Residences
(This article is the first in a three part series on the tax consequences of a short sale or foreclosure. This installment
will cover properties that qualify as a principal residence.)
The last thing a person involved in a foreclosure or short sale needs is a crushing tax bill, so it is important to
understand and be aware of potential tax consequences. When it comes to a qualified principal residence, taxes can be
avoided in most, but not all, circumstances.
A principal residence for tax purposes is a home that a taxpayer has owned and lived in for at least two of the past five
years. Keeping that definition in mind, we will consider both the capital gains tax and the tax on debt forgiveness
income that could result from a short sale or foreclosure.
Tax on Capital Gains
The gain/loss on a short-sale or foreclosure transaction is calculated as the market price or sale price minus the
taxpayer’s cost basis. In the event there is a loss, there is nothing to report for tax purposes, because a loss on a
principal residence or any personal property is not deductible. If there is a gain on the residence, then the taxpayer is
eligible to exclude up to $250K (or up to $500K for a married couple that files married filing jointly) of this gain.
Therefore, when it comes to a foreclosure or short sale on a principal residence, unless the capital gain exceeds the
exclusion maximums, there will be no capital gains tax.
Debt Forgiveness Income
Debt forgiveness income is the difference between the loan amount at the time of the foreclosure or short-sale and the
market price or sale price. As a general rule, debt forgiveness income is taxable, but there are some exceptions.
The Mortgage Forgiveness Relief Act of 2008 says that debt forgiveness income can be excluded if the debt can be
considered “Qualified Principal Residence Indebtedness” (QPRI). QPRI is any debt that is secured by a principal
residence and was incurred to acquire, construct or improve a principal residence.
Therefore, a potential income recognition problem does exist if a taxpayer had refinanced and used any “cash-out”
proceeds for some purpose other than home improvement. In that case, the income would be taxable unless the
taxpayer qualifies for an exclusion under the bankruptcy or insolvency exceptions.
Consult with a Tax Professional
This can be a complicated issue, so we recommend that anyone involved in one of these transactions consult with a tax
professional to review their particular situation. If you or someone you know is involved in a foreclosure or a short sale
and is concerned about the possible tax consequences, please feel free to contact our offices.
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