Tax Consequences After Real Estate Short Sale
Question: We borrowed money to purchase our home in Paradise Valley and our two expensive rental homes in Flagstaff. All three homes are now in short sale escrows. If the lenders approve these three short sales, will we have any tax consequences on the debt forgiveness on these three loans?
Answer: Probably not. Although the amount of any debt forgiveness on a loan is generally taxable income, and the lender will send a form 1099 to the Internal Revenue Service for the amount of the debt forgiveness, debt forgiveness on loans used to purchase homes is generally not taxable income. First, under the Debt Forgiveness Act of 2007 any debt forgiveness on a loan used to purchase a principal residence is not taxable income. Therefore, if the short sale is approved on your Paradise Valley home you should have no taxable income on any debt forgiveness. Second, in regard to your rental homes in Flagstaff, the Internal Revenue Service has ruled that there is no tax liability for debt forgiveness of non-recourse debt. See IRS Publication 4681, p. 11 (amended 12/11/08). Under Arizona real estate law, any loan used to purchase a home is generally non-recourse debt, i.e., the homeowner has no personal liability for the loan. See A.R.S. § 33-814(G). Therefore, you also should have no taxable income on any debt forgiveness on the loans used to purchase your two Flagstaff rental homes.
Note: If the lender erroneously sends a form 1099 showing any debt forgiveness, your tax return should nevertheless correctly show that there is no taxable income on the debt forgiveness on any of the three loans.