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Who pays taxes on a short sale?

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Posted On: 07/16/2008

Q: We owe $216,000 on our house; the current market value is $190,000. There is a purchaser interested in buying the property under a short sale for $152,000. If the bank accepts this amount would the homeowner be required to pay taxes on the $64,000 difference?

A: For many years unpaid mortgage debt could be regarded as “imputed income” in certain circumstances. This means that if a home loan was not fully repaid the borrower could potentially be taxed on any shortfall.

The Mortgage Forgiveness Debt Relief Act of 2007, introduced by Rep. Charles Rangel (D-NY), gets rid of the possible tax faced by homeowners. The catch -- as is always the case -- is that the new rules do not apply to all loans. For instance, forgiveness applies only to “qualified principal residence indebtedness” and not a mortgage secured by investment property. Forgiveness does not apply to amounts above $2 million -- not much of a hurdle for most homeowners. Also, the law ends on December 31, 2010, unless extended.

For specifics, please speak with a tax professional.

Q: I recently heard about a mortgage where the lender receives equity in the property instead of interest. Does this make any sense?

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A: In the U.S., “real-estate financing” means getting a loan and paying interest. However, this is not the case everywhere. In other places, the lender provides cash and receives an equity interest in the property. No interest is paid.

What’s interesting about these arrangements is that the “lender” becomes a part owner of the property -- and not just in good times. If the property goes up in value then the lender and the borrower split the profits. However, if the value falls then the lender is owed less or nothing.

There are now U.S. programs where lenders are willing to exchange cash for equity. As with any mortgage program, borrowers should consider the terms and conditions associated with each loan product with care.

For instance, how much money will you get? How much will you pay in up-front fees and charges? How much equity will go to the lender? Is the lender charging interest AND getting an interest in the property, a so-called “equity kicker?” Is there any requirement to make monthly payments? Who is responsible for property taxes and insurance payments? Is the owner ever required to pay back the loan?

And there’s more: Can the owner be forced to sell the property after a given number of years? Alternatively, is there an “exit” fee if the owner quickly sells? Does the “exit” fee decline over time and eventually disappear. Is any of the cash you receive taxable?

Another important question: Is the lender getting a percentage of the current equity or a percentage of future appreciation?

Suppose your home is worth $500,000 today and 15 years from now it’s valued at $850,000. Is the lender putting up $250,000 (less costs and fees) for a half interest in the property, or is the lender putting up, say, $100,000 for a half interest in the home’s appreciation, that additional $350,000?

Shared equity loans are sometimes marketed as an alternative to reverse mortgages. In such cases loans are only available to those of a certain age, say 65 or older. Some early reverse mortgage products had steep fees up front, high interest rates and required an equity split with the borrower. Today, such toxic financial products are believed to be entirely gone, however – just to be sure -- senior borrowers with an interest in such financing should look for FHA-insured reverse loans, so-called home equity conversion mortgages.

If you have an interest in a shared-appreciation loan, contact the lender directly for details and information. However, sign nothing until the proposed arrangement has been reviewed by a real-estate attorney or an attorney who specializes in elder law.

Q: My husband and I are past age 60. We sold our house for $105,000. We paid $82,000 for it 10 years ago. We installed hardwood floors; replaced the furnace, water heater and roof; and added a gas fireplace and new patio, all adding up to $102,000. Is there a tax on the $3,000 profit?

A: Many of your expenses -- such as the furnace -- represent normal costs of ownership. The new floors can be seen as a capital improvement, if you have receipts. Generally, there’s no federal tax on the first $500,000 in profits if married, or $250,000 if single, if you have lived at the property for two of the past five years. Age is not a consideration. For specifics, see IRS Publication 523, “Selling Your Home.”

Peter G. Miller is the author of The Common-Sense Mortgage and a veteran real estate columnist. Have a question? Please write to peter@ctwfeatures.com.

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