The Really BIG Problem with (Real Estate) Short Sales

Financial authors don't seem to be mentioning this problem and economists don't seem to be building this issue into their projections. First, let's describe what a 'short sale' is, not a stock market short sale (which is totally unrelated) but real estate short sales. A real estate short sale is when a homeowner, who is unable to make the payments on their house, put their house up for sale at a price below the amount of the mortgage, with the agreement of the mortgage company or bank that holds the mortgage.

The advantage to the homeowner is that no mortgage payments have to be made while it is listed, they get to live in the house tax-free, and a foreclosure doesn't show up on their credit report. The advantage to the bank is that they don't have to foreclose, they don't have to maintain the house , and they don't have to get into the business of reselling the home. They also don't get stuck with an illiquid asset that hurts their balance sheet.

But here is the timebomb. All homeowners who sell their property under a short sale are subject to paying tax on the amount forgiven. Escrow companies will send out 1099 forms, so the IRS will be fully aware of the homeowner's tax obligation. Sorry, the Homeowners Exemption on Gains doesn't apply. Here is what it says at the House of Representatives Ways and Means web site, which has the Statement of National Association of Realtors.

The news reports have not mentioned the tax problem that sellers in short sales and foreclosures will face if lenders forgive (i.e., do not require payment on) some or all of a mortgage debt at the time of disposition. These sellers just might get a visit from the IRS.

Current Law. Any lender that forgives debt is required to provide a Form 1099 information report to the borrower and to the IRS stating the amount of the forgiven debt. The Form 1099 is required in any circumstance when a debt is forgiven, whether it is a short sale, foreclosure, deed in lieu of foreclosure or any similar arrangement that relieves the borrower of the obligation to pay some portion of a debt.

I know someone who is going through a short sale now at $160,000 below the outstanding mortgage. I'm sure he doesn't know about the tax consequences. At a 28% Federal tax bracket plus the high state bracket (for California), he may owe in excess of $50,000. This is for someone who can't afford a $3800 per month mortgage. What is he going to do about the tax? What are all the thousands and thousands of short sellers going to do? What is the IRS going to do? If they issue a lot of liens, the short sellers won't be buying any houses, cars, or any other confiscatable assets for a long, long time.