I am filing for bankruptcy, should I do a short sale on my house?

With the housing market collapsing, it’s relatively common for a homeowner to be underwater on their home mortgage. My clients are no exception. Therefore, I am often asked about short sales and how they relate to bankruptcy proceedings.

Before we get ahead of ourselves, I need to first make sure we’re on the same page. A short sale refers to the sale of real estate for less than the principal balance due on the mortgage. In non-deficiency states like Arizona, the homeowner is likely to walk away with no liability (but no equity) and the lender agrees to accept less than the mortgage balance to service the loan.

To make this clear, let us consider an example. Suppose you bought your current home in 2006 for $300,000 with a 3% down payment, and thus a home equity of $291,000. Now consider that the appraised value of your home in 2010 has dropped to $200,000 and that a buyer is willing to pay this purchase price. A short sale would occur if your lender accepted the purchase price of $200,000 in satisfaction of the $291,000 mortgage.

Because Arizona is a non-deficiency state, you would likely walk away from this sale without any liability for the remaining balance, but you would have lost your initial 3% investment.

Historically, the biggest drawback to short sales is that canceled debt is a form of income and must be reported on Form 1099 to the IRS. This was then considered taxable income, excluding the following exceptions: bankruptcy debt, insolvency, farm debt, and non-recourse loans. Therefore, as a seller, you will be required to pay income tax on the deficiency on a short sale. Given the drastic fall in home prices, this could represent a large part of the change.

However, the Mortgage Debt Relief Act of 2007 added an additional exception to the cancellation of debt proceeds that benefits owners of submerged homes. Specifically, it allows the exclusion of the income made as a result of the modification of the terms of the mortgage on your habitual residence.

This law only applies to debts forgiven between 2007 and 2012 and pertaining to loans from a primary residence. A maximum of $2 million ($1 million if married filing separately for the tax year) of forgiven debt can be forgiven. The forgiven debt must still be reported to the IRS by filing a Form 982.

Juggling an underwater house is not easy. There are many options you can consider, only one of which is bankruptcy protection. Such matters must be carefully considered and decisions made based solely on what makes the most sense for your specific set of facts and figures. Again, if you have any questions regarding filing for bankruptcy in Arizona or short sales in Arizona, please feel free to contact me at my Phoenix office.