Q: I
owned a parcel of raw land as investment property in Arizona until
last month, when I sold it via a short sale. My $230,000 1099 is en
route. My battle with the IRS will start in 10 months … fun! I’ve
researched it and found that Arizona is a non-recourse state, but that
doesn’t apply for the investment property. Any advice? –D.S. in
California
A: Hmmm. Raw land, huh? Well, recourse vs.
non-recourse (the issue of whether your lender can/will sue you for the
deficiency) is a different but slightly overlapping issue from the tax
issue (whether the state or Internet Revenue Service will impose tax
on cancellation of debt income (CODI).
So, first, let’s tackle
the recourse issue. Now, you’re correct that Arizona’s non-recourse
rule does not apply to your situation because the property was an
investment (as opposed to your personal residence). That means that
technically the lender could sue you for the deficiency — the
difference between what you owed on the property and what they
recovered via the short sale (the $230,000 in debt that was canceled).
But
few lenders of properties in states that are ordinarily non-recourse
states are seeking deficiency judgments these days, as they’re really
not equipped to; most lenders who do pursue deficiency judgments are set
up with regular attorneys in those states that allow it, as a rule.
Additionally, if you happen to be pretty broke, you mayhave been evaluated by your lender as judgment proof,” i.e., not worth spending the legal fees to go after no a “can’t-squeeze-blood-from-a-turnip” line of reasoning.
There’s no way to
know 100 percent whether your mortgage lender will come after you, but
the odds do point in your favor. One thing — revisit your short-sale
approval letter and every document you signed during escrow and at
closing. It’s possible that they may have included a provision
whereunder the bank would waive your later liability for a deficiency
judgment.
If you can find that — it’s worth a call to your
broker or lawyer for help — then you can rest assured there’s no
lawsuit coming. If you can’t, you’ll not know for sure until the
statute of limitations has run: six years, if you signed the closing
papers in Arizona; four years if not.
Now, onto the tax issue.
For those who aren’t aware, mortgage debt that is canceled through a
short sale or foreclosure is normally subject to state and federal
income taxes; it’s known as cancellation of debt income (CODI) federally
and in California, and discharge of indebtedness (DOI) in Arizona.
However,
the federal and many state governments have put into place temporary
laws eliminating this tax in the cases of many short sales and
foreclosures; in fact, the federal version — the Mortgage Debt
Forgiveness Relief Act of 2007 — does not expire until 2012.
The
savvy researcher you are, you’re probably aware that most of the
temporary tax exemptions for short sales and foreclosures right now are
applicable only to personal residences.
However, there is one
other exemption that may alleviate or eliminate your tax burden: the
insolvency exemption the IRS has for CODI. If you can make the case —
which many folks can right now — that your net worth was zero or
negative at the time of the foreclosure, you may be able to get out
from under the federal income tax using the insolvency exemption.
Per
the IRS website: “Is cancellation of debt income always taxable? Not
always. There are some exceptions. The most common situations when
cancellation of debt income is not taxable involve … Insolvency: If
you are insolvent when the debt is canceled, some or all of the canceled
debt may not be taxable to you. You are insolvent when your total
debts are more than the fair market value of your total assets.”
Check out IRS Publication 4681
for more information about the insolvency and other exemptions you
might be able to invoke. My advice is also to have your taxes prepared
next year by someone who is very experienced with filing returns
including short sales and foreclosures — there are many certified
public accountants who are also real estate attorneys and possess this
expertise.
Choose a tax pro who will have your back and be able to
document and argue your case persuasively in person in the event of an
audit.
When it comes to your state income tax liability, this is
definitely a question I would refer to the CPA or tax attorney you
select. I don’t have the facts to know whether your DOI income would
require you to file a return in Arizona, or whether you can deal with
this in the context of your California income tax return — both states
have similar temporary CODI/DOI income tax exemptions to the federal
one (which won’t apply to you because this was an investment property),
but it’s not clear to me whether either or both of them will also
honor the insolvency exemption in your situation.
Psst – you should follow Trulia and Tara on Facebook, too!
Copyright 2010 Tara-Nicholle Nelson, reprinted via Inman News
If you find a
CPA/attorney who has worked with many California real estate investors,
undoubtedly they will have run into this issue before, as investing in
Arizona was a popular strategy a few years ago.
