LETTER: New tax to hit short sellers this season

Palm Coast Observer
Business

Dear Editor:

Starting this January, people “short selling” their homes started getting hit with new taxes they will have to pay to the IRS this year. For example, if you are in a short sale, and the “short” is $100,000, the IRS will input that amount as income to the seller, and they will have about $28,000 in taxes on that amount (depending upon your income bracket).

This means a person who typically earns about $40,000 per year will show an income of about $140,000 that year and have a tax payment to the IRS in the lump sum amount of about $29,000.

They will have to stoke a check to the IRS for that amount. I can’t imagine.

Much has been made of the expiration of a provision in the income tax laws regarding discharges of indebtedness with regard to real property transactions. That provision allowed taxpayers to exclude the amount of debt forgiven on short sales or foreclosures of real property, if the forgiven debt was related to the acquisition cost of the property and if the property was used as a principal residence.
But as the calendar rolled over from Dec. 31, 2013 to Jan. 1, 2014, that exclusion expired, meaning that, going forward, taxpayers may have to recognize income from the discharge of indebtedness if they relinquish real property in a short sale or foreclosure and the excess debt is forgiven.

Relief from discharge of indebtedness has almost always been available when a property owner sold property at a loss and the property was used in a business or was qualified farm-use property and the excess debt was discharged by the lender. However, in light of recent residential property struggles, a temporary provision was inserted into the tax code that allowed discharged debt related to a principal residence to also be excluded from the taxpayer’s income.

But that provision expired on Jan. 1, sending many “underwater” taxpayers into a panic.

The cause of this panic is understandable, especially in light of the fact that many taxpayers who short-sold their homes in 2013 or acquiesced to foreclosures are getting 1099’s from their lenders claiming they have thousands or hundreds of thousands of dollars in income from the discharge of indebtedness. The real question is whether or not the excess debt was actually discharged.

If the lender has not formally discharged the debt, there is no basis for the debtor to have to recognize income from that debt just because the lender is claiming a write-off deduction for the “bad debt.”

Simply: Anyone who lends money to someone else can claim a “bad debt” loss deduction if the lender has made all reasonable efforts to collect the debt. Of course, there must be evidence of the debt, and the lender may also have to prove that they attempted to collect on it or have evidence as to why it is not collectable.

What the deduction does not require, however, is for the lender to actually forgive the mortgage to claim the deduction. All the lender has to do is be able to demonstrate that it made a reasonable attempt to collect the debt and that further collection is unlikely. Claiming the deduction for a “bad,” or uncollectable, debt is not the legal equivalent of forgiving the debt itself, and the debtor is technically still on the hook regardless of whether the lender has taken a deduction or not.

As an example, assume a debtor short-sells a residence in 2014 and the excess debt is $100,000. The lender agrees to the short sale but does not formally discharge the debtor from the excess debt. In 2015 the lender issues a 1099 to the debtor claiming the $100,000 excess debt as discharge of indebtedness income to the debtor, indicating that the lender is taking a deduction for that amount as a “bad debt.” In 2016 the debtor wins the Florida Lottery to the tune of $10 million.
Does the issuance of the 1099 in 2015 preclude the lender from suing the debtor for the $100,000 excess debt after it finds out the debtor won the lottery? Of course not.

Issuing the 1099 simply means the lender is taking a tax position that it may have to reverse in a subsequent year under the tax benefit rule. That is, the lender claims the deduction now but may have to amend its filings later to account for a change in the circumstances for which it had previously claimed some tax benefit. The consequences to the lender are comparatively small as to the benefit of retrieving the balance owed, which is why the lender did not have a problem claiming the “bad debt” deduction in the first place. But to the debtor, the consequences of reporting the $100,000 of debt discharge as income can be devastating, if he does not have the means to pay the accompanying tax burden.

Unless Congress acts to reinstate the exclusion for debt relief from the sale of a principal residence, any person engaging in a short sale or submitting to a foreclosure should have the documentation carefully examined by an attorney to determine whether the lender is actually discharging the debt. If the lender is discharging the debt, the debtor will have to make arrangements to pay the tax that will follow when the income from relief of indebtedness is reported. If, however, the lender has any recourse to collect from the debtor then the debt is not actually being discharged. If the lender subsequently claims a deduction for a bad debt and issues a 1099 to reflect that deduction, it does not mean the debtor should report that amount as income.

The debtor should consult professional counsel to determine the status of the debt, and if that counsel determines the debt is still technically owed, then the debtor should disregard the lender’s 1099 because there is no income from the discharge of indebtedness.

Sincerely,

Michael D. Chiumento III
[email protected]
www.palmcoastlaw.com

—Michael D. Chiumento III has offices in Palm Coast, at 145 City Place, and Ormond Beach, 1414 W. Granada Blvd. Call 445-6702 or 868-5337.