Realtors Treading Sharky Tax Waters

I received a call this morning from a client that was in a huff about some information that his real estate broker had given him about cancellation of debt income.  Discharge of indebtedness income, or cancellation of debt income, or COD income can be present in a short sale.  I am heartened that the Realtor was aware of the issue, but I think he started swimming into some deep waters when he started advising his client on the ramifications of the transaction.  Those waters don't have a readily identifiable bottom and that butt clenching feeling you have is directly correlated to the sharkiness of that water.

 If we get into the way back machine and head into 1931, the US Supreme Court decided the Kirby Lumber case giving rise to this kind of income.  It has since been codified, but with the codification, there were a number of exclusions that came along with it.  Not all debt is created equal in the sight of the law, and particularly the debt that is canceled because someone has met hard luck.  Up until the beginning of this year, the Mortgage Debt Forgiveness Relief Act of 2007 that had been extended through 2013 provided most owner occupied real estate a break if the property went back to the bank.  So, when dealing with short sales and foreclosures through last year, there was an exclusion available up to $2M on COD income derived from the loss of your personal residence. 

That provision was supposed to be extended, and had been expected to be extended by Congress, but because of the political infighting of our broken two party system, sensible provisions like this were held hostage by both sides and never extended.  Its not too late, but we are starting to fear this one is dead in the water going into midterm elections.  Consequently, short sales and foreclosures this year do not have a readily available exclusion.  This is where Realtors have lost that nice sandy bottom that they were standing on the water gets dark and deep fast.

The Internal Revenue Code has more loop holes than a fisherman's knot and this is where my Realtor friends are just treading deeper water.  My suggestion is that if you don't like swimming with the legal sharks in deep water, then simply point your client in the direction of competent counsel.  The Realtor that advised my client simply didn't know that when I had suggested short sale to my client it was with full knowledge that another exclusion was readily available.

This particular client had gone through a bankruptcy.  Again, the hard luck aspects of the exclusions softens the landing for the client that is losing his property.  There are also exclusions for those that have extensive debt and would qualify for relief because of insolvency. My favorite for investors in residential real estate has to do with such properties held outside of a C-Corporation because the insolvency is essentially limited to the single property and not the taxpayer's complete portfolio.

So, before you get your client all worked up over tax issues on his short sale or foreclosure, have him speak with the sharks in deep water, preferably by phone, sometimes its hard to tell food and friends apart.