Short-sale tax fears are real

How the IRS views 'phantom income'
By: Ilyce R. Glink: Inman News
Q: We bought our home for $179,000 and because of health issues we sold our home through a short sale for $134,000. When we went to file our income taxes, our accountant told us we would have to pay taxes on the $45,000 loss our mortgage company took when we sold our home.

Is this true? I called the IRS and whoever answered the phone told me we would not owe taxes on the mortgage company's loss. But when my husband called, he was told we would owe about $13,000.

Ms. Glink, $13,000 is a lot of money for us to come up with! I read on the IRS Web site that if you owned your home for five years and you lived in it for at least two, a couple could be exempted from paying taxes on their home if did not sell for more than $500,000. It is Publication 523 that explains this.

My husband and I meet all of the tests listed in Publication 523. We had to sell our home because of my mental health. Our accountant tells us our situation is not what Publication 523 states. He tells my husband we have to pay taxes on the $45,000 for the loss because it's as if the mortgage lender gave us that money.

We need your help desperately. Tax time is upon us.

A: It's clear to me that you're a bit confused about IRS rules regarding profits and losses from the sale of property. In general, you and your spouse are each entitled to keep up to $250,000 in profits tax-free when you sell your home, for a total of $500,000, provided you have lived in your home as a primary residence for two of the past five years.

In your situation, you do not have a profit on the sale, you have a loss. Worse, you have a mortgage for a significant amount of money that you cannot repay. Your sale is "short" $45,000. The lender has wiped this off the books, which the IRS views as a gift of income.

Unfortunately for you and your spouse, you probably do owe tax on what the IRS considers to be "phantom income."

This cash, commonly referred to as "phantom income" simply because it doesn't exist in your pocket or bank account, is the forgiven amount of your loan. To the IRS, it's as if you earned another $45,000 last year. So, you now owe tax on what the IRS views as earned income.

If you don't have the $13,000 to pay off this bill, you will need to talk to the IRS to set up a repayment plan. Do this soon, because this issue won't go away, and if you don't address it now with the IRS, you will owe additional penalties on top of what you actually owned.

While this news is bound to be devastating for you, it doesn't sound like you had much of a choice. The only other thing you could have done would have been to rent the property and wait for your local market to rebound enough to at least pay off your mortgage in full.

Q: I inherited lakefront property valued at $150,000 dollars. My cost basis is zero. If I sell the property and purchase another property with the proceeds and sell it for a similar amount, how much I will owe in taxes?

A: My first question to you is when did you inherit this property? If you inherited the property and the estate valued it at $150,000, and you now sell it for $150,000, you shouldn't owe any tax whatsoever, other than possibly transfer stamps or local sales tax.

If the property has appreciated since you inherited it (let's say it's now worth $175,000) and you owned if for more than one year, then you'd owe capital gains tax of up to 15 percent plus state tax on the difference between the value of the property on the day you inherited it and the value of the property on the day you sold it.

If you inherited the property years ago when it was virtually worthless, and now it is worth $150,000, you'd owe capital gains tax plus state tax on your profits unless this home is your primary residence and you lived in it for two out of the last five years. If it was your primary residence and you lived there for the required time, you would pay no tax on the first $250,000 of profit ($500,000 if you are married).

If this is property that is now an investment for you, and you have profits, you may be able to defer those profits by using a 1031 tax-free exchange, which is a provision in the tax code that allows people to defer the payment of taxes on the sale of investment real estate. You will be required to sell your property and buy a replacement investment property that costs at least as much as the property you're selling. There are other rules to consider, and you need to follow these rules carefully.

If you decide to go the 1031 route, make sure you work with a competent "qualified intermediary" that can help you navigate the many rules associated with this kind of exchange. You should also make sure the intermediary is a reputable company that has been around for a while. You should also investigate how your funds will be secure while the intermediary holds your money until you buy a replacement property.

Please talk to your accountant or estate attorney for more details and other options.