Expert: Dick Dennis - 8/21/2007

Question
My family's CA home is currently being foreclosed on. We have the opportunity to conduct a "short sale" in lieu of letting the lender foreclose on the property. This involves selling the property below market value and the bank forgiving a portion of the mortgage and considering it paid in full. This is considerably better credit wise than letting the bank foreclose and it benefits the bank as well. However, I have been informed that there may be a tax liability involved. I have been informed by the realtor that the amount "forgiven" by the bank (the difference between what the home sells for and the mortgage balance) can be reported to the IRS as earned income for me.  I am currently insolvent due to being laid off earlier in the year and don't expect to have more than $21k in earned income and about $9k in unearned income from unemployment benefits. I was told that there may be a chance we would not be affected due to "capital gains tax" or something similar to that. This home has been our principal residence for the last two and a half years. In your professional opinion, will we be adversely affected by this type of transaction?

Answer
The bank will likely report the short sale to the IRS by sending you and them a 1099. That is considered income by the amount you were forgiven. However, if you are entitled to take advantage of the IRC 121 meaning any capital gains you have will be wiped out since you lived in your residence for two of the previous five years . . . then you need to talk to your favorite tax expert and find out how you stand. Is it a wash? Are they two separate taxes? I do wish you well.

Dick Dennis