Here’s a scenario that is unfortunately becoming all-to-familiar in today’s economy: Due to unfortunate circumstances, or a life-altering event, you’ve just finished selling your home “short” — meaning you were able to sell the home for less than what you owed to the bank. It was probably an excruciatingly painful decision to sell the home short in the first place, and an equally difficult task getting the bank to agree to do so.
But at least you’re relieved of the burden of paying for a home that you were no longer able to keep. Aside from a significant ding to your credit rating that comes from selling your home short, you’re finally free. The nightmare is over, right? Not so fast.
Something for Nothing?
It’s safe to assume this general rule of thumb when dealing with banks and the government: You don’t get something for nothing. Neither institution is in the business of giving away money (although you have to wonder a bit about that lately…) But when a short sale is completed, there’s definitely a “something” being given out.
Let’s use the following hypothetical scenario as the basis for our discussion: You owe the bank (or possibly multiple banks) $900,000 on your home. You have just sold it short (with the bank’s permission), for a price that will net the bank $700,000. This leaves a nice round number of $200,000 as a difference. Don’t think for a second that this $200K difference will be forgotten by either institution. And don’t be at all surprised if you get a knock on your door months later looking for some sort of repayment. Here’s why…
Banks = Debt.
To the bank, the $200K that they just “forgave” on the sale of the home looks like debt to them, and in some cases they can/will pursue the homeowner for that $200K after the sale. Ouch. There are some situations where they can’t or won’t try to collect the difference:
- It’s a “non-recourse” loan. There are certain loans that are deemed non-recourse, meaning the bank generally doesn’t legally have a right to pursue the homeowner to recover their loss. This may happen when the loan in question was used to purchase the home in the first place, or what’s known as a “purchase money loan.” In other words, it’s not a re-fi.
- It’s too expensive/time consuming. Some banks are barely staffed to handle the caseload of short sale applications, let alone chasing down any recoverable debt afterward. And what are the chances of recovering any money from someone who is broke in the first place?
- Right to recover is waived. It’s possible during the negotiation process to get the bank to sign away their right to pursue the resulting debt, regardless of whether is a recourse loan or not.
But make no mistake, the banks are in the business to make money, not give it away. In a trend that seems to be on the increase, some banks have resorted to selling this debt to a collection agency for a steep discount. That allows the bank to recover at least a portion of their loss immediately, and it gets them out of the “bill collector” role. It also means that you may start getting harassing phone calls from the collection agency.
Government = Taxes.
To the government, that $200k debt that was forgiven looks like income, even though you didn’t physically receive a penny. And we all know how or government loves to tax income. But several years ago, the federal government enacted the The Mortgage Forgiveness Debt Relief Bill of 2007 (aka HR 3648) which essentially kept the IRS from being able to tax distressed homeowners on forgiven debt, or “phantom income” as it’s sometimes called. The California Franchise Tax board followed the lead of the IRS until recently and was not taxing this phantom income either.
But because of ongoing budget battle, the State of California did not officially extend this tax relief past the 2008 tax year….yet. There’s a bill that has been kicked around in Sacramento that will extend the phantom tax relief, but it has been vetoed by the governor because of other unrelated items in the bill. For more details, click on this article from the Mercury News: Californians May Have to Pay Tax on Canceled Mortgage Debt.
What does this mean? If you sold your home short in 2009, you may be stuck paying taxes to the State of California on the forgiven debt. Even though it’s expected that the government will eventually extend the tax relief, the April 15 deadline is rapidly approaching. And as it stands now, that debt is taxable.
If you have sold your home short recently, or are thinking about doing so in the near future, you should seek the advice of a real estate attorney who has experience in short sales to fully understand what kind of loan you have and what your exposure may be. Realtors are only one of many facilitators in this process, and are not “short sale experts” as some may claim to be. Which reminds me…
The information discussed in this article is for informational purposes only, and should not be interpreted as legal or professional advice. Consequently, the author is not liable for inaccuracies or omissions. Interested parties are advised to consult with a qualified legal professional.
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