You might owe taxes if you sell your house with a short sale in Minnesota this year. That is because Congress let the Mortgage Forgiveness Debt Relief Act expire for 2014. Source (Source, Washington Post).
This act said that you don’t owe taxes on forgiven debt from short sale or foreclosure. This act expired at the end of 2013, and as of January 1, 2015 short sale forgiveness is taxable again.
The Minnesota legislature let a similar act expire at the end of 2012, so you will also owe Minnesota income taxes on forgiven debt.
WHY DO I OWE TAXES ON FORGIVEN DEBT?
American taxes are very complicated and don’t always seem logical. The best way to explain why you owe taxes on forgiven debt is as follows. We all know that we must pay taxes whenever we earn money, or get income. In the US, income gets taxed.
But you don’t pay taxes when you get money by borrowing it, right? When you swipe a credit card or take out a mortgage, you don’t have to pay taxes on the money you borrow.
This is because you are going to pay back the money, so it isn’t income since you didn’t “make” money. But if the lender later decides that you don’t have to pay the money back, then all of a sudden it looks like you made money when you took out the loan.
If a bank lends you $10,000 and then later decides that you don’t have to pay it back, then you are $10,000 richer. But wait, you never paid taxes when the bank lent you the $10,000, so you must pay taxes when the loan is forgiven.
WHY A SHORT SALE IS TAXABLE
In a short sale the lenders let a borrower sell a house for less than the full balance of the loans against the house, and the lenders agree not to collect the unpaid balance from the borrower. This agreement not to collect the unpaid balance is debt forgiveness, and is taxable.
For example, if you have a house with mortgage balances of $200,000, and do a short sale for $150,000, then you will owe taxes on the $50,000 that the bank forgave.
In Minnesota, this is only true for balances forgiven from a second or third mortgage or home equity line of credit.
If you only have a first mortgage, then you won’t owe taxes after a short sale because first mortgages in Minnesota are non-recourse. Read this article to learn more about recourse and non-recourse loans.
WHY BANKRUPTCY WILL SAVE YOU ON TAXES
Now we know that when the lender forgives a loan, you will owe taxes on the amount the lender forgave. But what if you file Chapter 7 bankruptcy or Chapter 13 bankruptcy?
The bankruptcy discharges the debt, so there is nothing for the lender to forgive. In fact, the tax code has very favorable treatment for people who file bankruptcy.
A bankruptcy discharge, unlike a short sale, is not taxable. If you want to sell your house in a short sale, then the best thing to do is file bankruptcy first, then do the short sale. This is because the bankruptcy will have discharged your liability for the loan, so it won’t be forgiven.
The bank will reduce its lien and take a loss at the closing, but because the bankruptcy discharged the debt to the lenders, they are not forgiving it at closing.
It is crucial that you file the bankruptcy before closing on a short sale to stop any debt forgiveness income.
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