Tax Treatment for Short Sales

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I received this question as a comment on an earlier blog and I thought it had a fact pattern that might fit a lot of people these days:

In 2005 I helped a friend from foreclosure by purchasing his home 210,000:( it was an intrest only loan) My tax advisor stated that since I already own a home I should not claim this home on my taxes in 2007. In 2008 I sold the home as a short sale 158,000. 30,000 of the loss I have to pay back as no intrest loan over a 30 year period. the other 23,000 I received a 1099c. if or to make matters worse, my so called friend claimed the interest on his taxes for 2008, 2007. Do I have any recourse with the IRS to minimize what I might have to pay.

Lots of things included in this one! Let’s start off with the tax treatment for the initial purchase back in 2005. The writer doesn’t say, but I’m going to guess that he bought the house for $210,000 and then rented it to his friend.

His friend paid a rental amount equal, most likely, to the interest payments.

What we don’t know is whose name the loan was in. If the writer stepped in and paid the loan current and then helped out with the payments from then on, there should be a document that substantiates a “wrap around” mortgage. In other words, he’s bought the property, but the original owner is still on the paperwork.

If the writer instead actually bought the property and it’s a brand new loan, then he would get the 1098 for the mortgage interest.

Either way, it looks like something was done incorrectly back in 2005. Most likely the writer should have taken an interest deduction as a Schedule E for a real estate rental.

The part that is confusing is that the writer got the Form 1099-C. That indicates that he has the loan. But, the previous owner took the deduction. The Form 1098 for mortgage interest would be in the same name as the guy who got the Form 1099-C for debt forgiveness. In other words, the interest on the loan would follow the guy who has the loan.

So, where are we now?

The writer has a property that he just got a short sale on. He has basis on that property. He has some interest deductions that he should have taken that he hasn’t.

First step is figure out what the basis actually is. Most likely it’s $210,000. But because he didn’t show the property as a rental on previous tax returns, there could be an argument that it’s an investment. That means he’s going to get hit with debt forgiveness income as ordinary income and can only take an offsetting loss of $3,000 per year. If instead, he can turn this into real estate investment first (probably amend some returns), he can pick up the interest deduction, create suspended losses and prove that it’s a real estate rental which means all of the loss can be offset.

As far as the guy taking the interest deduction when he shouldn’t have, that’s between him and the IRS.

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