During the subprime mortgage crisis, beginning in 2007, short sales became a common way for homeowners to dispose of their property. In a short sale, the bank allows you to sell your property for less than what is owed. The difference between the amount owed and the sale price, also known as the deficiency, would normally be considered taxable income under 26 U.S.C. 61(a)(12). For example, if a homeowner owes $200,000 on a home, and the bank receives $150,000 from the short sale, the difference of $50,000 would be considered taxable income to the homeowner, because it is money owed to the bank that the homeowner does not have to pay. This creates a large tax burden and is extremely problematic for people who are in the position of needing to short sale their property.
In response, Congress passed the Mortgage Forgiveness Debt Relief Act (MFDRA) in 2007. The MFDRA amends the IRS code to essentially exclude any short sale deficiency from counting toward an individual’s taxable income. In other words, that $50,000 owed to the bank that the homeowner does not have to pay will no longer be taxable as income to the homeowner. There are of course, exceptions, and it generally only applies to the short sale of principal residences where the deficiency is $2 million or less.
The MFDRA originally applied to short sales completed through December 31, 2014. Pursuant to the Protecting Americans from Tax Hikes Act of 2015 (PATH), it has now been updated to retroactively apply to short sales made in 2015 and to short sales made in 2016. Further, PATH allows the MFDRA to apply to short sales “subject to an arrangement that is entered into and evidenced in writing before January 1, 2017.” This means that taxpayers will not be taxed on the discharge of indebtedness related to a short sale completed in 2015 or 2016, or on a short sale agreed to in writing in 2016 but which doesn’t close until 2017.
If you have any questions about this or any other real estate matter, contact the real estate attorneys at Brown, Paindiris & Scott at 860-659-0700 or firstname.lastname@example.org.
26 U.S.C. 61: https://www.gpo.gov/fdsys/pkg/USCODE-2011-title26/pdf/USCODE-2011-title26-subtitleA-chap1-subchapB-partI-sec61.pdf
Mortgage Forgiveness Debt Relief Act of 2007, 110 P.L. 142, 121 Stat. 1803: https://www.congress.gov/110/plaws/publ142/PLAW-110publ142.pdf
Protecting Americans from Tax Hikes Act of 2015, 161 Cong Rec E 1821, Sec. 151: http://docs.house.gov/billsthisweek/20151214/121515.250_xml.pdf