Real Estate Tax Rules

With tax season here, confusion often reigns supreme when considering gains and losses. Often, real estate gives taxpayers a headache when dealing with the IRS. According to a report by the National Association of Realtors, as much as 18% of the home sales last year were short sales. This post will shed some light on the tax consequences of a short sale and how a taxpayer should treat the sale on your 1040 for 2009.

If you’ve ever prepared your own taxes, you probably know the general rule that a taxpayer must include as ordinary income the “discharge of indebtedness.” The basic application of this rule occurs when a creditor decreases the amount of debt owed by a debtor. This obviously applies to a short sale, in which the mortgagor allows the mortgagee to sell the property for less than the mortgage and discharges the rest of the debt.

The IRS considers the difference between the amount originally owed and the new, lower amount income that must be declared. According to analysis conducted by Clayton Holdings, Inc., a successful short sale typically results in about a 19% loss between the mortgage price and the sale price. This amount can be cumbersome- approximately $38,000 would be owed on a house worth $200,000.

However, there are certain exceptions to this general rule. Under the Internal Revenue Code, a taxpayer may exclude the “discharge of indebtedness” if: (1) the discharge occurs during bankruptcy proceedings, (2) the taxpayer is insolvent, or (3) if the property is business real estate. For more information, please look to the IRS Code § 108(a).

The first two exceptions are relatively straight forward. If you are in the middle of declaring for or have actually declared bankruptcy, you will be able to exclude the difference between your mortgage and the sale price of your home.

The third exception allows a little wiggle room. The obvious application of this provision allows a business owner who is short selling his property to exclude the “discharge of indebtedness” from his ordinary income. However, this exception may also apply to the taxpayer who is holding real estate as investment property for the production of income. Therefore, a landlord who rents out her real estate may be able to disclaim the “discharge of indebtedness” if she has a short sale on the rental property.

Please consult a tax professional for more advice on reporting and excluding income related to your short sale. He or she may be able to work with you to find a possible exclusion for your short sale income.