Is there a way to avoid taxes from a short sale?

July 30, 2014 by Dave Du Val, EA
Yellow house with white fence

Hey Dave,

I completed a short sale in 2014 and was wondering if it’s possible to avoid taxes on the difference. I sold it for $142,000, the bank got $127,000, and the outstanding principle was around $200,000. I was told by a friend that if the sum of all my assets at the time of the sale was equal to or less than the profit from the sale of the house I would be relieved of paying taxes on the sale of the home. Is that correct or is there any way to avoid the tax penalty on a short sale?

Kyle

 

Kyle,

The IRS allows you to exclude cancelled debt from income to the extent that you are considered “insolvent” immediately before the debt cancellation. You are insolvent immediately before the cancellation to the extent that the total of ALL of your liabilities exceeds the cash value or the fair market value of ALL of your assets immediately before the cancellation. For purposes of determining insolvency, assets include the value of everything you own (including assets that serve as collateral for debt and exempt assets which are beyond the reach of creditors under the law, such as interest in a pension plan and the value of retirement accounts). Liabilities include the entire amount of recourse debts (debts for which you are personally liable), and the amount of nonrecourse debt that is not in excess of the FMV of the property that is security for the debt.

Generally, Form 982 is used to show cancellation of debt excluded from income using the insolvency exclusion, but if you still have assets after the COD is accounted for, you may be required to reduce your basis in them. This is a very complicated area of the tax code, and we would recommend that you seek the assistance of a tax professional for your 2014 tax return to ensure that the COD and property disposition are properly reflected on your tax return.

Many people expect that a tax extenders bill will pass after the November elections, so be on the lookout for it later this year. The current bill includes another provision − the Qualified Principal Residence Indebtedness Exclusion − which could be beneficial for you.

Deductibly yours,

Dave

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