With the housing market crashing, it’s relatively common for homeowners to be underwater with regards to their home mortgage. My clients are no exception. So I’m often asked about short sales, and how they relate to bankruptcy proceedings.
Before we get ahead of ourselves, I must first make sure that we are on the same page. A short sale refers to the sale of real estate for an amount that is less than the principal balance of the mortgage payable. In non-deprivation states such as Arizona, the homeowner most likely leaves with no liability (but no equity) and the lender agrees to accept the less than the mortgage balance in fulfillment of the loan.
To clarify this, let us consider an example. Pretend you bought your current home in 2006 for $300,000 with a 3% down payment and thus a $291,000 principal mortgage. Now consider that your 2010 appraised value has dropped to $200,000, and the buyer is ready to pay this purchase price. A short sale will occur if your lender agrees to accept a purchase price of $200,000 to meet a $291,000 mortgage.
Because Arizona is a non-sufficient state, you may leave this sale without any liability for the remaining balance, but you will lose 3% of your initial investment.
Historically, the biggest downside to short sales was that canceled debts were a form of income and had to be reported on form 1099 to the IRS. This is then considered taxable income, excluding the following exceptions: bankruptcy debt, bankruptcy, farm debt, and non-recourse loans. So as a seller you will be required to pay income tax on the shortfall in the short sale. Given the drastic fall in house prices, this could be quite a change.
However, the Mortgage Debt Relief Act of 2007 added an additional exemption for cancellation of debt income that benefits underwater homeowners. In particular, it allows the exclusion of income realized as a result of modifications to the mortgage requirements of your primary residence.
This measure only applies to debts forgiven between 2007 and 2012 and relates to a primary residence loan. A maximum of $2 million ($1 million if married and filed separately for the tax year) debt that has been forgiven can be forgiven. Debt pardoned must still be reported to the IRS by filing Form 982.
Juggling an underwater house is not easy. There are many options for you to consider, one of which is filling out bankruptcy protection. They should be considered carefully, and decisions should be made based solely on what makes the most sense for your specific set of facts and figures. Again, if you have any questions relating to filing for bankruptcy in Arizona or a short sale in Arizona, please feel free to contact me at my Phoenix office.