If your clients are considering the sale of an “underwater” residence, they have a short window to qualify for the taxable income exemption.
By Loretta Hutchinson, CDFA, NCC
A fundamental part of divorce settlements is the division of assets and the satisfaction of liabilities. Any real estate owned jointly by a divorcing couple is considered a marital asset. But what happens if the divorcing couple owns a primary residence that is “underwater” or worth less than their mortgage?
In today’s economic environment, short sales have become a common tactic in the settlement of mortgage liabilities. In simple terms, a short sale is a settlement. The lending institution agrees to accept an amount for the property that is less than the amount owed by the divorcing couple on the property. Even though there can be a considerable difference, the lender agrees that the lesser amount is payment in full. For example, if you owe $300,000 on a home loan and you sell the home for $275,000 under the terms of a short sale, the lender agrees to accept the $275,000 as payment in full. Essentially, the lender has “forgiven” the $25,000 difference between what the couple owes and what they receive as payment for their property.
Taxable Income Exemption: Considering Certain Exemption
What are the tax considerations? Prior to 2007, any amount “forgiven” by the lender was considered income and taxable to the seller with certain exceptions due to title 11 bankruptcy, taxpayer insolvency, certain farm debts and non-recourse loans. This debt forgiveness (other than exceptions noted) created a potential income tax burden to the seller. This was something that needed to be considered when dividing this “asset”. In a divorce, it was required to determine when and who would be responsible for the payment of any tax liability due to a short sale.
In 2007, Congress passed the “Mortgage Forgiveness Debt Relief Act and Debt Cancellation” to address the number of “underwater” properties and promote a more orderly exit strategy for these homeowners through short sales and mortgage modification. The act states that the debt forgiven by the lending institution on “qualified principal residences” is no longer considered taxable income to the seller. It is important to note that this exception does not apply to investment properties or second homes.
How to Qualify for the Debt Forgiveness Exemption?
So what does this mean for you and your clients? The “Mortgage Forgiveness Debt Relief Act and Debt Cancellation” is set to expire at the end of 2012 as part of the Bush era tax cuts, more commonly referred to as “the Fiscal Cliff”. A short sale can take quite a bit longer than a typical home sale. If your clients are considering the sale of an “underwater” principal residence, they will need to have the sale completed by 12/31/2012 to potentially qualify for the debt forgiveness exemption. (Notwithstanding, any extensions to the Act or changes to the tax code between now and the end of 2012.)
Because of the complexity of the tax code and its application to each individual situation, an attorney must be well versed in the nuances of the “Mortgage Forgiveness Debt Relief Act and Debt Cancellation” to determine if a short sale is a solution for their divorcing clients and whether or not the sale will trigger unwanted tax implications. More information, including detailed examples can be found in Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments at the IRS website www.irs.gov/Individuals/The-Mortgage-Forgiveness-Debt-Relief-Act-and-Debt-Cancellation-. Also see IRS news release IR-2008-17.
Loretta Hutchinson CDFA, NCC is president of Financial Divorce Plan, LLC , specializing in Divorce Financial Analysis and Planning and Litigation Support. Financial Divorce Plan services family law attorneys and divorcing people in Pennsylvania, New Jersey and Florida.
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