Mortgage Short Sale Penalty is Back


It’s not just the Bush tax cuts.  At the end of this year another tax law expires.  In 2007 Congress passed the law that forgave the taxes due on the imputed earnings from selling your home at a loss.

Example:  You sell your house for $100K.  But your mortgage is for $150K.  You lost $50K and in a short sale, your bank agrees to absorb the loss.  The IRS considers that INCOME and is taxable at whatever rate you pay. 

For some homes, the value of your loss can be several years of pay.  But since that isn’t REAL money or income, there is no rational way you can prepare for it and save some of your ill-gotten gains to use for paying taxes.

Yes.  Only the US government can consider huge financial losses as “taxable income”.  This will make it even harder for people who are underwater to sell their homes using short sales.  Instead they will be driven into bankruptcy to unload their homes.  Given that as an alternative, it makes no sense for them to cooperate with their creditors.  Thus the market gets the wrong signals and the economy continues to spiral downwards.

The term blood from a turnip comes to mind.  How can Congress or anyone reasonably expect to collect any revenues at all from people who have lost all their home equity and are now being forced into bankruptcy?

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About Professor Hale

Currently living in Virginia
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7 Responses to Mortgage Short Sale Penalty is Back

  1. heresolong says:

    This has also applied for years to settlement of debt. I think the rationale is to prevent people from hiding income using “debt forgiveness”. Example, I hire you to write a blog post for me. Instead of paying you $50,000 I loan you $100,000 and you agree to pay if back over five years. After a year I settle the loan for $50,000 and you pay me back the $50k. The $50k that we wrote off is, in fact, income.

    I know the situation is a bit different with a house in that you don’t have the cash in hand but I think that would be the explanation.

  2. Yes. That makes sense. It also makes sense if you have been supporting an extravegant lifestyle by taking cash out re-fi’s several years in a row, in effect, making it “income”. But if is were not for the stupid and perverse income taxe rules, creating false incentives to hide income as something else, then rules to trap the work-around would not be needed.

    The fact is that the rules we all live under for income taxes are arbitrary and capricious, and men with good conscience cannot always steer clear of paying severe penalties. Because in the eyes of the IRS, there is no such thing as good conscience.

    If the government collected taxes at point of sale retain businesses instead, then whe whole elaborate mechanism for taxing income would be obsolete. But you can’t get to Full blown communism without graduated income taxes. And you can’t have graduated income taxes without income taxes.

  3. Callowman says:

    Can you cite the law, or at least the article about the law?

  4. Professor Hale says:

    Is your Google broken? I don’t bother to cite things any more unless there is a specific source I want you to see. .

  5. Tarl says:

    Only the US government can consider huge financial losses as “taxable income”… and it is especially galling for the recipients of that “income” that the US government created the problem in the first place.

    Oh well, just gonna be more foreclosures instead of short sales.

  6. okrahead says:

    Tarl said, “Oh well, just gonna be more foreclosures instead of short sales.”
    Well, in point of fact, the new/old rules for the IRS dictate that in the event of a foreclosure, the ENTIRE amount of the loan is now counted as income. So if you have a $200k house note and go into foreclosure, you owe income taxes for that $200k.

  7. Tarl says:

    @Okra,

    I did not know that!

    A brief glance at the IRS rule says the forgiven debt is not counted as income if you are insolvent or bankrupt.

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