You may find yourself in a position of having to short-sale a property as a real estate investor. If you do, be sure you understand the possible IRS tax penalty. Investor tax consequences can be very different from the tax consequences of a short sale for an owner-occupied home.
The IRS Comes Calling When You're Broke
The IRS considers a short sale to be debt forgiveness. Although I disagree with it, that means the IRS categorizes forgiven debt as income. They levy income tax on the money you never earned. As you likely know, in a short sale the seller receives nothing at closing. After commissions and other expenses, everything left on the table goes to the lender as partial repayment of the mortgage. At best, the seller is let off the hook by the lender for any of the debt not repaid. But the IRS still wants a chunk from the failed investment. Unless you are an accountant or tax specialist, you probably aren't familiar with the dreaded 1099c form that the lender sends to the IRS. This form reports the amount of forgiven debt. The IRS counts it as income for the tax year.
When You Don't Need to Fear the IRS
There is a big exception when the short-sale house was your primary residence. The U.S. Congress made primary residence short sales exempt from the forgiven debt laws when the short sale market was heating up. That law is known as the Mortgage Forgiveness Debt Relief Act of 2007.
But they didn't apply the law change to investors.
Still, if you are an investor making a short sale, there is a clause in the old law that may save you from paying taxes on the income you never received. Qualifying for this tax exemption requires that you be financially insolvent at the time the debt was forgiven. This isn't necessarily limited to the property that you sold short. It may or may not include other assets that you own. Both personal and business assets. But it could depend on how you have your investment business structured.
This is a very good reason to hold each investment property as a separate business entity. Individual circumstances and various state laws determine the best business entity to use but a Limited Liability Company (LLC) is often the right choice.
When each investment or business asset is held as an individual entity, the short-sale property is highly likely to be insolvent at the time of the sale. In that case, IRS shouldn't target your personal income or the income from your other business holdings. Never just take my word for it. Check with your tax adviser first. All hope is not lost if you didn't have the foresight to take this precaution before selling an investment property in a short sale. Another option is personally qualifying as insolvent at the time of the sale. But you have to follow the IRS rules to demonstrate insolvency.
Completing the Insolvency Worksheet that comes with IRS Publication 4681 determines if you were insolvent at the time of the debt forgiveness. It's as simple as adding up all of your liabilities and assets. If your liabilities (including the amount of debt forgiven) are more than your assets (including the price of the short sale) you were insolvent at the time of the sale and do not owe taxes on the forgiven debt.
As always, check with a competent tax adviser to see how this applies to your specific circumstances.
Author bio: Brian Kline has been investing in real estate for more than 30 years and writing about real estate investing for seven years. He also draws upon 25 plus years of business experience including 12 years as a manager at Boeing Aircraft Company. Brian currently lives at Lake Cushman, Washington. A vacation destination, a few short miles from a national forest in the Olympic Mountains with the Pacific Ocean a couple of miles in the opposite direction.