Hurry and Cash In on Short-Sale Tax Savings

by Amy Hoak

An increasing number of homeowners who are underwater on their mortgage are selling their homes by short sale, and that could become an even more popular option during the rest of the year.

That’s partly because of a law set to expire at the end of 2012 that offers tax relief for homeowners who sold their home in a short sale or have had some other sort of mortgage debt forgiven or canceled, such as in a foreclosure or modification that included principal reduction. While there are efforts in Washington to extend these tax benefits, it’s hard to guess whether they’ll be renewed.

So those who think they might be able to take advantage have been stepping up, while they still can.

“Everybody [considering a short sale] needs to talk to a CPA and see if now is the time for them to get off the Titanic and in a lifeboat before this law expires,” said Marge Peck, associate broker and co-owner of Discover Arizona Real Estate in Mesa, Ariz. The company specializes in short sales. “I’ve just hired more staff. We’re prepared for the tsunami of people saying ‘I’ve waited long enough, nothing’s going to change.’”

Short sales are transactions in which the borrower owes more than the home is currently worth, and the lender agrees to accept less than the full mortgage payoff at closing.

The current savings for taxpayers is significant.

Say a homeowner took out a $200,000 mortgage on a home, and subsequently became underwater by about 20%, or $40,000, during the housing downturn. Without the current tax law, if the bank forgives that amount the borrower is underwater, such as through a short sale, they’d be subject to pay taxes on that forgiven amount, since the Internal Revenue Service regards it as income.

So for someone in the 25% tax bracket, forgiveness of $40,000 would mean a $10,000 tax bill at the end of the year, says Mark Luscombe, principal federal tax analyst for CCH, a Wolters Kluwer business and a provider of tax, accounting and audit information, software and services.

“Of course, the concept always strikes people as strange. They’re struggling and trying to get debt forgiven and then are hit with a tax,” Luscombe said.

To help taxpayers during the housing bust, Congress passed the Mortgage Debt Relief Act of 2007, removing that tax burden. For taxpayers, up to $2 million of forgiven debt (or $1 million for those married filing separately) is eligible for the exclusion, according to IRS.gov.

The law has been renewed once already, Luscombe said. Trade groups such as the National Association of Realtors are currently lobbying for the relief to be extended once more.

But eventually this law is expected to expire. It’s just a matter of when: “This one is probably going to sunset at some point. It’s a question of whether Congress thinks this is the right time or not,” Luscombe said.

It’s also worth pointing out that taxpayers in so-called “non-recourse” states may be protected from having to pay these taxes even when the law expires, he pointed out. Homeowners would be best served by seeking out the advice of a tax specialist for help in their local area.

Short sales rising

Short sales made up 9.1% of all home sales in March, up from 7.39% in March 2011, 6.67% in March 2010 and 4.79% in March 2009, according to figures from CoreLogic, a provider of consumer, financial and property information.

Pre-foreclosure sales were up 25% in the first quarter, compared with the first quarter of 2011, according to a report from RealtyTrac, an online marketplace for foreclosures. Homes in the foreclosure process are often—though not always—sold as short sales, said Daren Blomquist, vice president of RealtyTrac.

“I think we will continue to see them go up,” Blomquist said. “It’s like the pattern you saw with the home buyer tax credit—the biggest spike is at the end of the deadline. I would expect to see a similar pattern with the pre-foreclosure sales.”

But short sales don’t have to be for homes in the foreclosure process, as Peck pointed out. True, the lender requires a homeowner hardship before a short sale is considered. But that doesn’t always have to be a financial hardship: It could be that a family grows with more children and needs to move into a larger home or the homeowner has a medical condition and needs to move to a home without stairs, for example, Peck said.

In fact, in six out of 10 short-sale listings her company takes on now, the borrower is current on his or her mortgage, Peck said. While banks may want a monetary contribution from the borrower in this case, the situation often means less damage to the homeowner’s credit score, she said.

“I work with homeowners that brought properties at the wrong time because the market was sky high… now so many homeowners don’t know what to do,” she said.

Almost 16 million U.S. homeowners with mortgages were underwater in the first quarter of 2012, meaning they owe more than their home is worth, according to recent data from Zillow, a real estate website. But 90% of those underwater borrowers are paying their mortgage on time.

There’s still time

While short sales have notoriously taken a long time to complete, there’s still time for sellers to get these transactions done before the end of the year, Peck said. The key is working with someone who has experience dealing with short sales and will be able to move your case along.

Lenders may be more open to approving these transactions, too: “The fact that the foreclosure process has become lengthy and costly and risky for lenders is diverting them away from foreclosure and toward the short sale as an alternative to foreclosure,” Blomquist said.

Also, in June, new policies go into effect for Fannie Mae and Freddie Mac mortgages in an attempt to streamline short sales. Mortgage servicers will be required to review and respond to requests for short sales within 30 days of receiving a short sale offer, the Federal Housing Finance Agency announced in April. They’ll have to provide weekly status updates if the short sale is under review beyond those 30 days, and will need to get a final decision to the borrower within 60 days of the offer.

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