"Are there any tax consequences to a short sale or foreclosure if the bank forgives the unpaid part of the loan?"
The biggest issue financially in a short sale or foreclosure is whether the mortgage holder(s) will forgive the full amount of the loan(s) not covered by the sale of the property. As many have found to their detriment, payments may be expected by the lender(s) at closing, or afterwards, for outstanding balances. Assuming, however, that the lenders have agreed to accept the short sale or foreclosure sale price as payment in full of the mortgage or home equity loan and formally issue a forgiveness of loan document to the former homeowner, the story does not end here. The IRS still has something to say. Forgiven debts are considered to be income to the former debtor and subject to taxation. They must be reported on your tax return as income and taxes paid. In recognition of the difficult times we are living in and the fact that so many homeowners were being forced into foreclosures or short sales as jobs were lost and the economy spiraled downwards, the Mortgage Relief Act of 2009 was passed to provide relief to such homeowners. An exclusion to the taxation of the forgiven debt was extended, providing the debt had been incurred to purchase, build, or improve the debtor’s primary residence.
And there lies the rub.
For many, many people, the equity in their home, which previous to the real estate bubble bursting, just kept rising and rising, became the favored way to finance a myriad of other needs and wants besides building a room addition or putting on a new roof. Encouragement to refinance and tap the ever rising home equity to pay off credit card debt, pay for kids’ college expenses, take a vacation, buy other property, finance living expenses during a divorce etc. was rampant and many succumbed. The equity in the home became like an ATM machine to be tapped as needed. This portion of the forgiven debt is NOT excluded from taxation. It must be reported and taxes must be paid on it. So, if this applies to your situation, it is important that consideration be given in your divorce negotiations as to how this tax burden will be allocated to the parties so that each will be prepared at tax time to meet their responsibilities.
Marcia B. Kraus, CFP, CPA, CDFA, formally heads Divorce Financial Strategies, an independent firm in Naperville, IL. She provided advice for clients dealing with the financial issues in and after divorce.