Guiding Your Clients Through Short Sales & Foreclosures

Matt Fetick Keller Williams Real Estate Podcast

Now that the Mortgage Debt Forgiveness Relief Act has ended, here’s what you as an attorney need to know to guide your clients through a foreclosure or a short sale.

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One of the most common questions I’ve been asked in recent weeks is, “What do we do now that the Mortgage Debt Forgiveness Relief Act has ended?” This act was designed for homeowners who went through a short sale or foreclosure to avoid paying taxes on the forgiven debt.

If you’re an attorney and you have one or multiple clients who are asking themselves the same thing and looking to you for guidance, there are a couple things you need to understand.

Whether you do a short sale or a foreclosure, the canceled debt portion is considered potential income to the sellers. In a foreclosure, a short sale, and a deed-in-lieu of foreclosure, your clients will receive a 1099 form for the forgiven balance. Does that make it a taxable event, though? During the height of the market crash, the Mortgage Debt Forgiveness Relief Act decided that it wasn’t.

Now that that act has ended, the question becomes whether to do a short sale or a foreclosure and what happens to the forgiven debt.

To figure this out, use publication 4681 of the IRS Circular, which is titled “Canceled Debts, Foreclosures, Repossessions, and Abandonments.” It explains how the IRS looks at the taxation on the forgiven debt.

The good news is that if the short sale occurs on the primary residence, chances are the primary residence is an exclusion to the canceled debt and will not be a taxable event. Additionally, even if they don’t qualify under that, they may qualify under insolvency. The publication has a chart that you can use where you add up all of your client’s assets and liabilities, and if they have negative equity across their entire income and they’re insolvent at the time of the short sale, then the canceled debt is a non-taxable event.

The 4681 will be your guide for your clients.

This publication will be your guide for your clients. Keep in mind that the biggest benefit between foreclosures and short sales is that when you do a short sale for one of your clients, the bank is accepting the payoff as payment in full and they give up their right to pursue the deficient balance. That is not true for foreclosures, though. The bank has the right to collect the debt on a foreclosure.

You won’t see this right away, but banks are now selling that forgiven debt off to debt collectors who—now that the economy has improved—are going after the folks for their deficient balance. The nice thing about the short sale is there is finality in it. For foreclosure, there’s a pretty big window to pursue that deficient balance.

If you’re contemplating how to advise your client on a short sale, a foreclosure, or a deed-in-lieu, or you need help interpreting the 4681 publication, give me a call so we can talk. I’m also conducting a continuing education class for the family law section next month where you can get your continuing education credits, so if you’d like more information about that, I’d be happy to provide it to you.

If you have any other questions, don’t hesitate to reach out to me. I’m here to help.