Did the Short Sale of your Marital Residence Create a Tax Liability for You?

Did the Short Sale of your Marital Residence Create a Tax Liability for You?

When Congress passed the Protecting Americans from Tax Hikes Act (PATH Act) late in 2015, they included in it an extension of the mortgage debt exclusion that had expired at the end of 2014. That provision was created under the Mortgage Debt Relief Act of 2007, at a time when the real estate market went into decline and many homeowners faced mortgages they could not afford on homes that were suddenly “underwater,” or worth less than the outstanding mortgage. The initial act, which was extended through the end of 2014, changed the basic tax rules so that taxpayers who engaged in a short sale and/or underwent a foreclosure of their underwater home did not have to declare the discharged debt as taxable income or pay income taxes on the amount forgiven. The recent extension of the mortgage debt exclusion is retroactive through all of 2015, and extends through the end of 2016. It may also be applied to mortgage debts discharged in 2017, if the discharge follows from a written agreement entered into before the end of 2016.

This exclusion from income of discharged mortgage debt became a particularly useful and important feature of resolving equitable distribution matters and finalizing divorce cases while it was in effect. Its recent revival/extension may provide very good news to divorcing parties whose former marital homes were short-sold or foreclosed in 2015, and who, if not for the extension of the tax break, might be wrestling with how to handle a substantial tax liability in the form of debt forgiveness in their equitable distribution/divorce proceeding. Likewise, for those currently engaged in, or even contemplating, divorce proceedings that may result in a short sale of the marital residence, it may be prudent to try to complete that transaction, or at least enter into a contract for it, before this year is out. In any event, there are limits to what debt qualifies for the exclusion from income, and it is important for divorcing parties to understand whether and how the extended tax break applies to their situation.

To be excluded from income, the debt forgiven must be what the IRS defines as “qualified principal residence indebtedness.” That means that it must be debt incurred to buy, build, or substantially improve your main home, and it must be debt secured by your main home. Your main home is the one you live in most of the time, and you cannot claim to have more than one main home. Almost all conventional mortgage debt on a main home would qualify under this definition, but the question of second mortgages and home equity loans (HELOs) or lines of credit (HELOCs) is not as clear. If the second loan was used to refinance a first mortgage, and the second loan was used to build, buy, or substantially improve your main home, it will likely qualify for the exclusion, but only up to the amount of the first mortgage at the time you took out the second. If the second mortgage, HELO or HELOC were used for things like vacation travel, or even for such “necessities” as medical expenses or college tuition, and even if it is secured by your home, it may not qualify for the exclusion from income. If your divorce involves a short sale and/or foreclosure in which that sort of debt is being discharged, you and/or your divorcing spouse may be facing a tax liability for debt forgiveness that must be addressed by the terms of your property settlement agreement or the court’s order in equitable distribution.


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About the author

About Lawrence Welsh

A funny thing happened to Larry (Lawrence C. Welsh) on the way to his professional career in the practice of law. After graduating from college and before entering law school, he took an extended tour through the hospitality industry, working his way through both the service and business sides of hotels, restaurants and resorts in six states and the District of Columbia. Taking the business acumen and the ever-watchful attention to detail so well-honed during that experience into his lifelong passion to practice law has led Larry to his position as Chief Legal Counsel and head of the firm’s Forensic Support Team. Before joining the firm, Larry worked in the public defender’s office, through which he added an array of advocacy skills and trial experience to his resume. Since joining the firm in 2003, Larry has handled a full range of family law issues, which he continues to do, while lending experience and direction to others in the firm, particularly where and when the resources of the Forensic Support Team are most appropriate. Larry is also licensed in New Jersey, and he leads the firm’s New Jersey team operations. Larry is a multi-year “Top Lawyer” honoree in Main Line Today magazine, and he has been named as an “Awesome/Top Attorney” for family law and divorce in Suburban Life Magazine. Larry is an active member of the bar associations and family law sections of Delaware County, Chester County, and the state of Pennsylvania.