1) How is the tax amount computed when you short sale your primary residence?
Since we are talking about a Short Sale there obviously won't be any Capital Gains tax to worry about. You also will PROBABLY not have any tax based on the IRS' "Debt Relief" codes provided the Short Sale is completed by the end of 2012 (see answer to your last question below). Here's why:
On 12/20/07 President Bush signed into law a bill passed by Congress: HR 3648 â€“Mortgage Forgiveness Debt Relief Act of 2007. This eliminates the â€œphantom taxâ€ on foreclosures, short sales or other discharges of debt on a primary residence through 2012. For example, a property is worth $650,000, and the mortgage balance is $700,000. Under the old rules, if a lender forgave the $50k difference as part of a foreclosure, short sale, refinance or loan modification, the borrower had to claim the $50k as income and pay federal income taxes on that amount (by the way just so the borrower didnâ€™t forget, Banks typically would send a 1099 at tax time so they could write this off as an expense). The discharged mortgage balance must be on the taxpayerâ€™s principal residence.
For more info see the link under question 3 below.
2) What are the pros and con's of short selling?
Short Selling is the least damaging option if one is also considering a foreclosure, so I suppose that would be the primary "pro." Furthermore, if you are considering a foreclosure as your other option there really is no "con." This is for a couple of reasons:
A) A Short Sale is a transaction where the mortgage lender agrees to accept a lower amount than is owed on the property so a sale of the property can take place. From a "getting back on your feet" perspective as a new homebuyer, a SS has a much more forgiving recovery timeline.
For example, if a "new" borrower has had a prior short sale they may be considered for a new mortgage without a specific time period having elapsed provided the following conditions of the short sale were met:
-The mortgage on which the short sale occurred was not delinquent; AND
-Cannot have any 60 day lates on their mortgage 12 months prior to the credit report date; AND
-The borrower was not obligated to repay any amount associated with the short sale, including a deficiency judgment.
If the above requirements are not met, the short sale must be treated as a pre-foreclosure (delinquent payments) sale. This means a 2-year period before one could buy a home again. A foreclosure will have a 5-year period.
B) There are also credit considerations. This is what I'm hearing from a credit-scoring specialist who has been in the biz close to two decades:
Immediate affect â€“ With a short sale, you may be able to keep payments current (avoiding the derogatory scoring there), and you can negotiate with the lender as to how it is reported to the bureaus. For example, if the bank reports the account paid and closed, youâ€™re better off than if itâ€™s reported as being settled for less than owed. That may be a bit of a long shot, but the point is you have some negotiating range. Foreclosures go on to public record, where short sales do not.
Bouncing back -- Credit bureaus put short sales in a different scoring bucket than foreclosures when generating a score. The foreclosure bucket is dealt with more severely in that it takes longer to recoup the points lost by the event. Besides the scoring by the credit bureaus, lenders (read Fannie & Freddie) allow a return to the best rate pricing sooner with a short sale (2 years) than with a foreclosure (5 years)
Other Considerations -- Credit scores hit in a range of 80-200 points from best case to worst case with short sales. Figure itâ€™s closer to 200 points with a foreclosure. This is consistent with other articles Iâ€™ve seen.
- Beware of the Promissory Note that stays on. In some circumstances, a bank will agree to a short sale if the Seller agrees to sign an unsecured promissory note for some additional amount. This obviously would allow for the lender to recoup some of its lost money after the short sale. However, if the burden of that debt leads the Borrower into bankruptcy, then the Borrower has the worst of all worlds. That is, there is a BK as well as a foreclosure on the credit report. Thatâ€™s one more public record; it lasts for 10 years, hurts score additionally, and makes it harder to bounce back.
3) Are there differences between primary residence and investment properties on a short sale?
Catherine is dead-on with advising a Tax Professional regarding this question. There are subtleties with the "mortgage debt relief act of 2007" but there are also recourse/non-recourse loan considerations as far as a possible deficiency judgment against you.
For more info see: http://www.irs.gov/individuals/article/0,,id=179414,00.html
You really need to talk to your tax advisor about the calculations. The mortgage debt relief act of 2007 offers some help for homeowners short selling a primary residence, but it needs to be your original purchase money loan (if you refinanced to a new company or with cash out or got a heloc and spent money on bills, cars, whatever it may not apply and you may not be protected).
See my website for several articles I've written about why and why not of a short sale, then let me know if I can answer any further questions.