One of the goals of a seller in a short-sale, as well as the seller's attorney, is to have any outstanding debt forgiven as part of the transaction. The rational is that the seller is already losing any money it had in the property as a result of the short-sale, that last thing it wants to do is pay money as a consequence of the same. However, what many sellers do not realize is that forgiven debt can be construed as income, which can be taxed by the government.
The Mortgage Forgiveness Debt Relief Act (the "MFDRA"), is an exception to forgiven debt being construed as income. The MFDRA holds that debt that is forgiven by a lien-holder is not considered income when the (i) debt is used to acquire, construct, or substantially improve a home, and (ii) home is the debtor's primary residence. (See I.R.C. Sections 108(a)(1)(E), 108(h), and 163(h)(3)(B)). As such, under the MFDRA not only is it possible for forgiven debt from a primary mortgage not to be construed as income, but forgiven debt from a home equity line of credit (the "he-loc") also may not be considered income, provided the proceeds were used to substantially improve the borrower's home. (See I.R.C. 163(h)(3)(B)). However, if the proceeds from the he-loc were used to pay off credit cards or student loans, the said debt - regardless if it secured by the debtor's (seller) primary residence - would most likely not be dischargeable. (Id).
Although MFDRA does not apply to investment properties, it is possible that the debt forgiven on such properties would not be deemed income? However, whether such debt would or would not be considered income depends on how the debt was reported. For example, if the property was referenced on a debtor's (seller) tax returns as an investment property that was being rented out, there is a possibility that any gain in income would be off-set by any loss that the debtor (seller) incurred as a result of the short-sale. Alternatively if the property was a vacation home or not listed as an investment property where the rents were listed as income, there is a possibility that the debt forgiven would be construed as income. I raise these issues because a seller in a short-sale needs to be prepared as to the potential tax ramifications or benefits that may pertain to the transaction. However, to better understand the tax consequences of forgiven debt under a short-sale a short-sale seller should really speak with an accountant or tax attorney.
Andy Roth, New Jersey Real Estate Lawyer
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