Short sale or foreclosure of a principal residence.

• Author: Picha, Steve R.

It would be a bad dream for any homeowner: selling a home when the debt that secures the property is greater than its fair market value (FMV). With the real estate market slowing, more homeowners are discovering that this can actually happen.

When the real estate market was booming, homeowners either borrowed heavily to buy in at the top or took out home-equity loans, which added to their debt. Now that the real estate market has cooled, some homeowners are finding that their debt exceeds the FMV of the property. Not only do they owe money to the bank and are forced to sell, but there could be some unexpected income tax consequences as well.

This item discusses the tax implications of short sales and foreclosures, both of which may be only a missed mortgage payment or two away, and are often the only solutions to an otherwise uncertain situation.

Definitions

Short sale: Through a bank workout program called a short sale, lenders approve a house sale if a homeowner is behind on payments and owes more than the property's FMV. The lender takes a discount by allowing the homeowner to sell the home at less than the mortgage debt. Short-sale contracts help lenders unload unwanted property and avoid many expenses associated with the foreclosure process. The bank will lose a little now to avoid losing more in foreclosure.

Deed in lieu of foreclosure: This is a deed instrument in which a mortgagor (the borrower) conveys all interest in real property to the mortgagee (the lender) to satisfy a loan that is in default and avoid foreclosure. It offers several advantages to both the borrower and the lender. The principal advantage to the borrower is that it immediately releases him or her from most or all of the personal indebtedness associated with the defaulted loan. The borrower also avoids the public notoriety of a foreclosure proceeding and may receive more generous terms than in a formal foreclosure. Advantages to a lender include a reduction in the time and cost of repossession and additional advantages if the borrower subsequently files for bankruptcy.

Foreclosure: This is the legal process reserved by the lender to terminate the borrower's interest in a property after a loan has been defaulted. The lender sets a minimum price that it is willing to accept for a property to be sold at auction. When the process is completed, the lender may sell the property and keep the proceeds to satisfy its mortgage and any legal costs. Any excess proceeds may be used to satisfy other liens or be returned to the borrower.

Lenders do not want to own real estate and will go to great lengths not to foreclose. It is a process that...