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short sale taxes on investment property, proving insolvency?

Hi, two months ago I did the closing on the short sale of an investment property I used to own. Prior to sale of the property, my net worth might have been about $10K in assets & $20K in a 401K account. The property was sell short by $110K. My question concers the tax liability on this. I think I was insolvent at the time of the closing, meaning that I would owe the IRS on taxes for this year, more than my total assets value. Right after the closing I started investing most of my cash in the stock market and I’ve made a few thousand dollars in profits. Are these post-short-sale winnings going to be affect my insolvency for the sale of the property? I think I read somewhere that one needs to prove insolvency right before the short sale took place. Is that so? Thank you!

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3 Responses to "short sale taxes on investment property, proving insolvency?"

  1. Bash Limpbutt's Oozing Cyst© says:
    Your insolvency is figured at the moment that the debt is forgiven by the lender. That might be several years down the road, if it even happens at all. Just because they approved the short sale does NOT necessarily mean that the remaining debt has been forgiven.

    Also keep in mind that it’s possible to have a short sale showing a loss of cash on the table but a taxable capital gain. That’s especially true with investment property where the depreciation recapture must be taken into account. The tax on that gain won’t go away, insolvent or not.

  2. a tax lady says:
    Bash has given you a good overview. You can also skim through IRS pubs 908 and 4681.

    HIRE someone to do your taxes. Do this for the year of the sale, especially if it was rental property and for the year of the 1099-C.

    The short sale will generate a 1099-S. The amount still owed is almost always recourse debt. If it is, the debt will stay on the books of the lender for a while and they will try to collect from you. In the event they cancel the debt (did you realize they can sell it to someone else?) entirely, they will issue a 1099-C. This can be years away. As Bash points out, the insolvency calculation is as of the date of the 1099-C, not the date of sale. Read your paperwork. If it says anything about a “Recovery” they are going to try to get the money if they can.

    You say investment property. What kind? What were you using it for? As Bash points out, the calculation of gain/loss is independent of financing (after all, some people pay cash for their assets). Was it rental property? I’ve seen some people have a gain; I’ve seen others have an NOL. If it was land, did you capitalize any carrying charges?

  3. Michael Plaks says:
    Jose,
    Both of my colleagues provided excellent answers to one part of your question. But they left some other issues untouched, so I will try to fill the gap.

    1. The tax liability on short sale starts with one fundamental question: what was your gain (or loss) on the short sale itself. This question has nothing to do with $110k shortage. It has to do with what you paid for the property originally, including original loan (basis of the property), depreciation of this property if you took any, closing costs, and the selling price negotiated at the short sale (reported on form 1099-S).
    Example: Selling price $300k minus $20k closing costs minus initial purchase price $250k plus depreciation $30k = $60k taxable gain.
    What was owed on the property does not matter. What the property was worth on the open market does not matter.

    2. This taxable gain could be large, could be zero or could be a loss. No way to tell without doing complete calculation. And my example was over-simplified, so I will second the advice of my colleague: hire somebody who specializes in real estate and knows the small but important details of this calculation. The gain is taxable, and the loss is deductible on your 2011 return.

    3. Insolvency has to do with a totally different issue, tax-wise: cancellation of debt. To you, it looks like part of the same transaction. To the IRS, it’s an entirely new game. Cancellation of debt happens when (and if) your lender decides to not pursue you for the unpaid balance of the loan. I’m not sure if you realized this, but the lender most likely RETAINED the right to demand the unpaid balance from you, even though you do not own the property anymore. Check with your local real estate attorney to be sure. But it’s safe to assume that, unless the lender specifically released you from the debt IN WRITING, they can still come after you. If so, you debt is not cancelled, and there is no tax issue, and no need to discuss insolvency.

    4. Provided that your lender did release you from debt, either during the short sale or at some later point, the lender will issue form 1099-C, cancellation of debt. It will be issued whenever the cancellation becomes official. One way to avoid paying tax on this cancelled debt is to claim insolvency. If you receive 1099-C tomorrow, then tomorrow is the day to calculate insolvency. If all your debts as of tomorrow exceed the value of all your assets as of tomorrow – you’re insolvent and off the hook as far as taxes on cancelled debt.

    5. Important to keep in mind: taxes on cancellation of debt are IN ADDITION to taxes on the short sale. These are two separate calculations, often done in two separate tax years. One does not cancel the other and does not duplicate the other.

    6. Finally, make sure your concept of insolvency is correct. If, per your example, your net worth is $10k in assets plus $20k in 401k – you have a positive $30k net worth, and you are NOT insolvent. Insolvent means negative net worth. Before the short sale, you could subtract $110k and arrive to negative net worth. But insolvency will be figured on the day the lender forgives your debt (if ever) and not on the day of short sale. The forgiven debt may end up being the same $110k or some other number – no way to predict. That number will be the one to use for insolvency calculation.

    Michael Plaks, EA, Houston TX
    Specializing in Real Estate tax law
    http://www.MichaelPlaks.com

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