If you are struggling financially, and in talks with your mortgage company about a short sale, you should be sure to ask them whether you will owe any taxes when you sell your house.
You need to know this information because the IRS and the Minnesota Department of Revenue have both decided that if someone forgives a debt, then the debtor must pay taxes on the amount of debt forgiven.
This is important, because:
- A federal tax law that used to protect short sales on peoples’ houses expired at the beginning of 2014
- The Minnesota tax law protecting homeowners doing short sales expired at the beginning of 2013
WHAT IS DEBT FORGIVENESS?
Debt forgiveness is when a lender or creditor tells the borrower or debtor that the debtor no longer owes the money to the creditor., although this is not the same as a charge off.
A charge off usually means that the lender sold the debt to another creditor, and the debtor now owes the money to the new creditor.
Debt forgiveness happens in a number of contexts.
It can happen when:
- You settle a debt for less than the full principal balance
- A creditor decides to be nice and let you off the hook (usually a friend or family member)
- You sell your home in a short sale
This article is mostly concerned with short sales and taxes.
What is a short sale?
In a short sale:
- The borrower and the lender(s) agree that the borrower can sell the house for less than the full balance of all of the loans
This only happens with houses that are underwater, meaning that the mortgages against the house are for more money than the house would sell for.
- The bank gets all of the money from the sale, and they agree not to pursue the borrower for the rest of the money
The fact that the lenders won’t pursue the borrower for any part of the mortgage that wasn’t paid back by the sale creates debt forgiveness. The mortgage lenders agree to take less than the full principal balance to satisfy the loan.
WHY IS DEBT FORGIVENESS TAXED?
In the United States, people must pay taxes on income, and the IRS has decided that forgiveness of debt is income.
Think about it this way:
- If someone loans you a thousand dollars, and then says that you don’t have to pay the money back, you are a thousand dollars richer, right?
The IRS wants their share of that one thousand dollars, so you must pay taxes on it, just like any other income (Source, IRS).
Why did Minnesota pass temporary debt forgiveness laws?
When the housing crash started, the IRS and Minnesota Department of Revenue decided that it was unfair to tax people for debt forgiveness based on mortgage loans that were inflated because of the housing bubble.
They passed temporary laws saying that debt forgiveness from short sale or foreclosure of your house, with some limitations, would not be taxed.
The Minnesota law for this expired at the beginning of 2013, and the federal law for this expired at the beginning of 2014. This means that if you have a short sale, and any of your second or third mortgage is forgiven, then you will owe taxes.
As of January 1, 2015 short sale forgiveness is taxable again.
In Minnesota, you don’t owe taxes for forgiveness on a first mortgage, because Minnesota is a non-recourse state.
Non-recourse means that the lender can only take the property, they don’t have recourse against the borrower personally.
WHY IS BANKRUPTCY BETTER THAN A SHORT SALE?
That’s right, even if you discharge a million dollars in bankruptcy, you do not owe taxes on it.
So if you are thinking about doing a short sale on your house, it is better to discharge the debt in bankruptcy, and then let the bank foreclose on the house.
If you use this strategy, then you won’t owe any taxes, and you will probably be able to stay in the house without making the mortgage payments for an additional 6 months or more. Bankruptcy also has the advantage of discharging other debts, and is only a little bit worse for your credit than a short sale.
Now you know why filing for bankruptcy in Minnesota is better than short sales, why not see how we can help you?
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