Think Short Sales Are Tax-Free? Not So Fast

Short sales are heating up now that the Obama administration has increased the amount of cash handed out to help people move and to encourage lenders to make deals.

Having just wrapped up a story about the options available to underwater borrowers, I learned some interesting things about the tax ramifications of short sales that I hadn’t understood before.

When lenders agree to accept less than the principal amount owed in a short sale, the amount of debt that’s cancelled is considered income. Congress, recognizing that getting hit with a big tax bill after narrowly escaping foreclosure felt like salt on a wound, passed a law waiving income taxes for up to $2 million in debt on principal residences through 2012.

But there’s one factor that may mean both federal and state income taxes on cancelled debt: A cash-out refinance. If you bought your home years ago but refinanced during the boom to take advantage of higher prices, pulling money out to pay credit card debt or buy a car or anything that wasn't used to "substantially" improve the property, that money is taxable income. No escaping the tax man on that one, says Orange County, Calif. accountant Monica Rebella.

On top of that, people who refinanced their home, becoming underwater in the process, and sold later may face capital gains tax on the sale unless they fall within the federal exemption ($250,000 for a single filer, $500,000 joint.) Those limits will, for the most part, cover everyone, but I’d bet that in high-priced housing markets like California, one could run into trouble.

Finally, notes Rebella, if you took advantage of the first-time home buyer credit and then do a short sale or foreclosure within three years, you have to pay the credit back.

An earlier version of this post stated that California Governor Arnold Schwarzenegger had vetoed a bill providing state tax relief for debt cancelled in a short sale. The California legislature subsequently passed a similar bill reinstating the tax relief, which Schwarzenegger's office indicated he would sign.

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