Short sale affects seller’s taxes, credit and balance may still be owed

Q: We are planning to sell our house, but we are going to have to do a short sale. I have been told the lender will send me a 1099 for the amount that is forgiven.

Since I have a mortgage insurance policy on my Federal Housing Authority loan, will that help to offset the amount that I would be responsible for on my taxes? I'm told Ginnie Mae actually owns my loan, but Citi Mortgage services it. Thanks for any info you can give. -- Ronnie C., Las Vegas

A: This is an interesting question with a fairly complex answer.

Since there are some legal issues involved here, I enlisted the expertise of Deanne M. Rymarowicz, legal counsel for the Greater Las Vegas Association of Realtors.

Here's her response:

"Generally speaking, the mortgage insurance you're questioning protects the lender, not the borrower.

According to the U.S. Department of Housing and Urban Development, 'FHA mortgage insurance provides lenders with protection against losses as the result of homeowners defaulting on their mortgage loans. The lenders bear less risk because FHA will pay a claim to the lender in the event of a homeowner's default. Loans must meet certain requirements established by FHA to qualify for insurance.'

To answer the rest of your question, any amount of a home mortgage that is forgiven by a lender is typically considered income and the borrower may have to pay taxes on that amount.

But there is some good news. The forgiveness of certain mortgage debt may be excluded from income under the Mortgage Forgiveness Debt Relief Act and Debt Cancellation Act of 2007. This federal law generally allows taxpayers to exclude income from the discharge of debt on their principal residence for loans discharged in calendar years 2007 through 2012.

Under this new law, the lender will issue a 1099-C form for any forgiven debt, but the borrower will only need to report that amount on their tax return, not include it as taxable income. Certain criteria apply, so it is essential that you speak with your accountant and/or an attorney to see whether you qualify.

In addition, the Internal Revenue Service has created a booklet that discusses the exemption and provides examples at irs.gov/pub/irs-pdf/p4681.pdf.

You should be aware that lenders have other options besides forgiving the debt and issuing a 1099 form.

A lender may approve a short sale and agree to release its lien on a property to let the sale go through, but the lender may then ask you to sign a promissory note agreeing to pay back the amount of your loan not paid off by the sale.

The lender then has the ability to legally pursue you for the balance. The statute of limitations on a contract such as a promissory note is six years.

If your financial hardship is permanent and you can't pay back the balance, talk with your attorney about your options.

You should be aware of your lender's position before you close the short sale transaction. Be sure to get it in writing, and be sure to read and understand what will happen.

Finally, a short sale may have an adverse effect on your credit score. I strongly recommend talking to a credit counselor in an nonprofit organization such as Consumer Credit Counseling Service about your specific situation. The Web site is cccsnevada.org. Research any company that makes claims about helping with credit issues and problems.

As you can see, a short sale has many legal, tax and credit implications. Using a Realtor to help you through the process is a good place to start. To thoroughly understand how a short sale will affect you, other professionals may need to be consulted.

Sue Naumann is the president of the Greater Las Vegas Association of Realtor and has worked in the real estate industry for nearly 30 years. GLVAR has nearly 13,500 members. To ask her a question, e-mail her at ask@glvar.org. For more information, visit lasvegasrealtor.com.