Remember last month when I talked about how you may owe taxes after a short sale on your personal residence? The same problem may happen if you have an investment property with problems. Depending on your situation, especially how much you owe on your property and to whom, you may have a huge tax problem on your hands.
Plenty of help for a primary residence
Over the past few years, there have been a number of new laws and government programs set up to help homeowers. For example, the Mortgage Forgiveness Debt Relief Act of 2007 generally allows taxpayers to exclude income from the discharge of debt on their principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualify for this relief, and these advantages will be in place until 2012. Also, as the economy continues to be rough for the average taxpayer, there will be continued political pressure to provide relief in the form of tax breaks and rule changes.
Why investment properties are different
To put it simply, an investment property is not a primary residence, so many of the breaks that homeowners get when it comes to tax breaks for forgiven debt doesn't exist. For example, if you are personally insolvent on the day that you do a short sale on a personal residence, you probably don't owe any taxes on the value of the forgiven debt. If the same thing happens with an investment property, it isn't a personal residence, and you may owe on the forgiven debt.
Nightmare scenario: you lost money but still owe taxes
There are many ways that this can happen, and the following is an easy to follow example. An investor bought a four-unit apartment house for 0% down three years ago, and the rent from the tenants easily covered the mortgages and other costs. In the last year, two very bad things happened - real estate prices dropped 30%, three of the tenants moved out or just stopped paying rent, and you are bleeding money like crazy. You find another investor who takes it off your hands, and you think you are lucky because the mortgage holder allowed a short sale on your property.
Things look great until a few months later when you get the 1099C from the mortgage holder and you realize that the forgiven debt is considered income, and you owe taxes on the difference between the purchase price and the sale price. The only problem is your apartment house was your only significant investment, and after you sold it and took care of all the other costs, you were living paycheck to paycheck. You have a tax bill that is is equal to your annual income, and Uncle Sam doesn't want a sad story, he wants you to show him the money.
How to deal with this problem
The best way to deal with the problem is to avoid it by not selling the property. If this is not an option, then it is time to get either creative or proactive. Creative would be working with the mortgage holder to change the terms of the deal, or working with real estate management company to find paying tenants. If you have no choice but to sell, then at least prepare for the consequences by contacting the IRS about your situation. They will still want their money, but they may be open to negotiating a payment agreement with you.
Short sellers, who get lenders to forgive a portion of the debt in order to complete a sale, are also at risk because lenders will often leave their options open to come back and collect later. If you are involved in a short sale, make sure to review your agreements carefully, preferably with the help of a competent professional.
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