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 sold short by $110K. My question concerns the tax liability on this. I think I was insolvent at the time of the closing, meaning that I would owe the IRS no 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 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!
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 strongly suggest you 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 tax 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.
Hello Michael . . . nice write-up and explaination of the tax implications on a short sale of investment property.
One quick question: if the short sale generated a taxable loss AND the borrower was insolvent on the date the 1099-C was issued, would the 1099-C income be excluded (i.e. insolvency) AND the short sale loss be recognized on the borrower’s tax return? If so, this sure seems like a taxpayer funded benefit to the investment property owner . . . ?
Brian
Great question, Brian. It brings up an entirely new level of complexity – complexity that I did not mention in my post. You prompted me to write a follow-up post and address your question. I will include a link to the follow-up post shortly. Thank you for reading and thinking! Michael Plaks.