Short Sales, Capital Gains, Taxes, and Procedure 580e(a).

February 6, 2012

Here’s a hypothetical scenario that will make it easy to understand short sales, capital gains, deficiency judgments, tax consequences, and procedure 580e(a). Just in case you aren’t familiar with the term short-sale, it means that a lender is being repaid part of a loan and transferring the property to a new owner (this is not a foreclosure in either title-theory or lien-theory states).

Depending on the state and current statutes of civil code there are differences between how these figures are seen for tax purposes and deficiency judgments. Here’s an example: $750,000 is outstanding on a mortgage, with current market conditions it is reasonable that the property could be sold at $625,000 (so this leaves a difference of negative $125,000) that neither the bank or the seller fund during the transaction.

Prior to Procedure 580e(a) this $125,000 was seen as taxable income, as it was a “gain” in the eyes of the IRS. In addition to that, the $125,000 could also be deemed a “repayable sum” in a deficiency judgment. The combination of both of these things can make short sales an incredibly difficult process for all parties involved.

In an effort to remedy this situation, Code of Civil Procedure 580e(a) was passed, and now when a lender accepts a short sale it acknowledges that it has been paid in full and cannot seek a deficiency judgment on the amount owed.

How Procedure 580e(a) impacts taxes, and hypothetical, yet, unrealized “gains” is a subject too sticky to explain in a bog post. If you need some guidance in this area, feel free to give me a call.