With the collapse of the housing market, it is relatively common for a homeowner to be underwater with regards to their home mortgage. My clients are no exception. Thus I am often asked about short sales, and how they relate to bankruptcy proceedings.
Before we get ahead of ourselves, I should first make sure we are on the same page. A short sale refers to the sale of real estate for an amount less than the principal balance owed on the mortgage. In non-deficiency states such as Arizona, the homeowner likely walks away without liability (but without any equity) and the lender agrees to accept an amount less than the mortgage balance in fulfillment of the loan.
To clarify this, let’s consider an example. Pretend you purchased your current home in 2006 for $300,000 with a 3% down payment and thus a mortgage principle of $291,000. Now consider the 2010 appraised value of your home has fallen to $200,000, and that a buyer is ready to pay this purchase price. A short sale would occur if your lender agreed to accept the purchase price of $200,000 in fulfillment of the $291,000 mortgage.
Because Arizona is a non-deficiency state, you would likely walk away from this sale without any liability towards the remaining balance, but you would have lost you initial 3% investment.
Historically, the biggest detriment to short sales is that canceled debt is a form of income and must be reported on form 1099 to the IRS. This was then considered taxable income, excluding the following exceptions: bankruptcy debt, insolvency, farm debts, and non-recourse loans. Thus as the seller you would be required to pay income taxes on the deficiency in a short sale. Given the drastic fall of home prices, this could amount to a pretty hefty chunk of change.
However, the Mortgage Debt Relief Act of 2007 added an additional exception to the cancellation of debt income that benefits underwater homeowners. Specifically, it allows the exclusion of income realized as a result of modification of the terms of the mortgage on your principal residence.
This act only applies to indebtedness forgiven between 2007 and 2012 and pertaining to loans of a primary residence. A maximum of $2 million ($1 million if married and filing separately for the tax year) of forgiven debt may be forgiven. The forgiven debt must still be reported to the IRS by filing a Form 982.
Juggling an underwater home is not easy. There are many options for you to consider, just one of which is filling for bankruptcy protection. Such matters should be carefully considered, and decisions should be made based solely on what makes the most sense for your specific set of facts and figures. Again, if you have any question pertaining to filing bankruptcy in Arizona or short sales in Arizona, don’t hesitate to contact me at my Phoenix office.