Short Sale Taxation Factors

A complicated mix of factors affects the taxation of short sales.

Our federal tax code defines how short sales are taxed; however, the federal tax law predicates its application on certain state law determinations as well as other non-tax federal law issues. In the area of short sale taxation, the accountant must often look to the taxpayer’s legal counsel for assumptions addressing Arizona’s real property statutes and cases, Arizona contract law, federal loan regulations, and other areas. This information is needed before the accountant can confront the more direct task of correctly interpreting the sometimes imprecise tax law itself. The fact that the term “short sale” is a fairly recent addition to IRS publications, does not portend well for detailed guidance on the subject.

Generally speaking, an accountant may be required to bifurcate the short sale in to a sale followed by a debt forgiveness calculation, unless the borrower is not personally liable on the note. The issue of whether the borrower is personally liable on the note is generally the most significant factor affecting the homeowner’s economic outcome (both tax and non-tax). This recourse or nonrecourse status requires very different accounting treatment, and sometimes is not easily discernable. For this reason, accountants are sometimes requested to analyze a transaction using both assumptions, in order to more adequately prepare a client for potential outcomes.

In addition to the determination of the recourse/nonrecourse nature of a debt, the timing of such status will generally affect the tax outcome. It is not unusual for a note secured by a deed of trust to change status from recourse to nonrecourse, or vice-versa. This change can result from an agreement, a trustee’s sale, the statute of limitations, bankruptcy, federal/state statutes, or other actions taken by either the lender or the borrower.

Guidance in all areas of law affecting the economic outcome of a short sale to the seller will be forthcoming. It is important to stay in contact with your accountant, lawyer, and real estate professional during the short sale process.