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short sale Tax Implications

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Latest post Thu, Sep 22 2016 9:40 PM by Taxagent. 3 replies.
  • Thu, Sep 22 2016 9:54 AM

    • just Wes
      Consumer
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    • NV
    • Posts 2

    short sale Tax Implications

    bought principal residence in Nevada in 2005, moved to new home in May 2013 and converted original residence into rental property (new home is about a block from old home and the reason for the move was that we needed a different housing configuration for my elderly father in law who was living with us at the time).  Initially paid $355,000 for home, FMV at time of conversion was approximately $220,000.  The house was rented until February 2016 when it was put on the market as a short sale. I am now about to short sell which will result in a 1099-c of about $110,000 with a closing in October.  I am afraid that I have screwed myself by renting the home too long and it then taking too long for the short sell would happen and it has now been my principal residence for only 18 months of the 60 months before the closing of the short sale.

     I am selling the house for about $160,000 less then I paid for it, but because it has been rental property I am only going to be potentially able to deduct as loss on investment property the amount between the FMV at time of conversion and the sales price, with no consideration given to what I actually paid for the property.

    Am I missing anything? thanks for any suggestions

  • Thu, Sep 22 2016 11:11 AM In reply to

    Re: short sale Tax Implications

    just Wes:
     I am afraid that I have screwed myself by renting the home too long and it then taking too long for the short sell would happen and it has now been my principal residence for only 18 months of the 60 months before the closing of the short sale.

    That would matter only if you had a gain from the sale of the home. Internal Revenue Code (IRC) section 121 allows you to exclude from income the gain you realize on the sale of your principal residence when certain conditions have been met, among them that you have both owned and lived in the property as your principal residence for at least 2 of the 5 years immediately preceding the date of the sale of the property. But from your facts it appears you will not have a gain on the sale so you don’t need the benefit of § 121.

    just Wes:
     I am selling the house for about $160,000 less then I paid for it, but because it has been rental property I am only going to be potentially able to deduct as loss on investment property the amount between the FMV at time of conversion and the sales price, with no consideration given to what I actually paid for the property.

    Right. You cannot deduct the loss realized on a personal residence. The loss in value that occurred prior to turning it into a rental is not deductible. You may deduct the loss that occurred from the start of being rental, though the basis will be reduced by the depreciation you took or could have taken, which will reduce the loss realized.

    just Wes:
    I am now about to short sell which will result in a 1099-c of about $110,000 with a closing in October.

    The taxation of any debt cancelled (discharged) in the sale is a separate issue from the gain/loss realized on the sale. The general rule is that discharged debt is taxable income. However, you may qualify to exclude that debt either as discharge of qualified personal residence debt or under the insolvency rule. See IRS Publication 4681 for details.

  • Thu, Sep 22 2016 12:19 PM In reply to

    • just Wes
      Consumer
    • Not Ranked
    • Joined on Thu, Sep 22 2016
    • NV
    • Posts 2

    Re: short sale Tax Implications

    Thanks Taxagent for the information, I mentioned the 2 years out of 5 because that seems to be the criteria for it to be a principal residence which seems to be the definition that has to be met to be eligable for the  mortgage debt relief act.  It seems that if it doesn't meet the requirements then I am not eligible to exclude from my income the 1099-c amount and there doesn't seem to be any provision to allow me to exclude 75% since I met 75% of the principle residence rule.

  • Thu, Sep 22 2016 9:40 PM In reply to

    Re: short sale Tax Implications

    just Wes:

    Thanks Taxagent for the information, I mentioned the 2 years out of 5 because that seems to be the criteria for it to be a principal residence which seems to be the definition that has to be met to be eligable for the  mortgage debt relief act.  It seems that if it doesn't meet the requirements then I am not eligible to exclude from my income the 1099-c amount and there doesn't seem to be any provision to allow me to exclude 75% since I met 75% of the principle residence rule.

    A lot of people seem to misunderstand this. IRC § 121 sets out the rules for the exclusion of gain on the sale of a principal residence. The basic rule is in § 121(a), which states:

    “Gross income shall not include gain from the sale or exchange of property if, during the 5-year period ending on the date of the sale or exchange, such property has been owned and used by the taxpayer as the taxpayer's principal residence for periods aggregating 2 years or more.”

    Notice that the statute says that the taxpayer must have been used as the principal residence for a period of 2 or more years out of the five years immediately preceding the date of sale. In other words, the two out of five years does not define what a principal residence is; rather, the rule is saying what amount of time it must have been used as a principal residence in order to qualify for the gain exclusion. Nowhere in IRC § 121 defines principal residence. Rather, the IRS and Treasury issued a regulation that defines what a principal residence is:

    “(b) Residence—(1) In general. Whether property is used by the taxpayer as the taxpayer's residence depends upon all the facts and circumstances. A property used by the taxpayer as the taxpayer's residence may include a houseboat, a house trailer, or the house or apartment that the taxpayer is entitled to occupy as a tenant-stockholder in a cooperative housing corporation (as those terms are defined in section 216(b)(1) and (2)). Property used by the taxpayer as the taxpayer's residence does not include personal property that is not a fixture under local law.
    (2) Principal residence. In the case of a taxpayer using more than one property as a residence, whether property is used by the taxpayer as the taxpayer's principal residence depends upon all the facts and circumstances. If a taxpayer alternates between 2 properties, using each as a residence for successive periods of time, the property that the taxpayer uses a majority of the time during the year ordinarily will be considered the taxpayer's principal residence. In addition to the taxpayer's use of the property, relevant factors in determining a taxpayer's principal residence, include, but are not limited to—
         (i) The taxpayer's place of employment;
         (ii) The principal place of abode of the taxpayer's family members;
         (iii) The address listed on the taxpayer's federal and state tax returns, driver's license, automobile registration, and voter registration card;
        (iv) The taxpayer's mailing address for bills and correspondence;
        (v) The location of the taxpayer's banks; and
        (vi) The location of religious organizations and recreational clubs with which the taxpayer is affiliated.”

    Treas. Reg. § 1.121-1. Notice that there is no particular time requirement specified in that rule. A home could be your principal residence for 1 month or it could be your principal residence for 30 years. But to get the gain exclusion under § 121, the home had to qualify as your principal residence for 2 of the 5 years preceding the date of sale.

    Now, the rule for exclusion of debt discharged for “qualifed principal residence indebtedness” applies to cetain loans you took out to acquire or improve your principal residence. The statute says that the term principal residence “has the same meaning as when used in section 121.” In other words, the same as the defintion from the regulation I quoted above.

    So, it appears that what matters for the exclusion of discharged debt here is whether the home was your principal residence at the time you took out the loan for it. I think that would certainly be a reasonable return position to take in my view. You may wish to consult a local tax lawyer or CPA for specific advice on that in your circumstances.

    Note, too, that even if the qualified personal residence indebtedness exclusion does not apply, the insolvency exception likely does. Unless your net worth prior to the sale was positive you likely have nothing to include in income for the debt discharged in the sale.
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