Short Sale or Foreclosure?
In my practice over the last couple of years, I have met with countless clients to discuss with them their "underwater" homes. Typically, these clients want to know what are their options with their homes and the outstanding loans. They ask if they should pursue a short sale, or if they should walk away allowing the home to go into foreclosure, or what is their potential liability to the lender should either a short sale or foreclosure occur.
In addition to these common questions, I am also repeatedly asked about a borrower's potential tax liability after a foreclosure or a short sale.
Under the Internal Revenue Code, if a borrower is liable for a debt that is canceled, forgiven, or discharged, that borrower will likely receive a Form 1099-C, Cancellation of Debt, and must include the canceled amount of the debt as part of his or her gross income for tax reporting purposes. However, there are certain exclusions or exceptions that may apply. First, if you receive a Form 1099-C but the creditor is continuing to try to collect the debt then the debt has not been cancelled and you do not have taxable cancellation of debt income.
In a typical foreclosure or short sale situation however, if Arizona's Anti-Deficiency statute applies to protect the borrower, the creditor is barred from pursuing the outstanding outstanding balance (or the deficiency) but the question remains for borrowers as to whether or not they will have to pay taxes on the portion of the home loan that has been wiped out.
The answer is probably "NO" ...
The IRS's website specifically states that cancelled debt is not always taxable and that there are a number of common exceptions. The foremost exception states that if the underlying loan that has been cancelled is a non-recourse loan, there is no tax liability. According to the IRS, "A non-recourse loan is a loan for which the lender's only remedy in case of default is to repossess the property being financed or used as collateral. That is, the lender cannot pursue you personally in case of default. Forgiveness of a non-recourse loan resulting from a foreclosure does not result in cancellation of debt income.
Importantly, where Arizona's Anti-Deficiency statute protects borrowers after a foreclosure or even a short sale, that loan would be considered a non-recourse loan and the above exception would apply.
For a more comprehensive explanation of when cancelled debt may or may not be taxable, the IRS's website includes some very good information. Also, if you want to know if Arizona's Anti-Deficiency statute applies to your particular situation, take a look at this article and give us a call to schedule a consultation so that you might have all of your questions answered.