Tax consequences on Arizona Short Sales
Chris Combs of Combs Law Group, PC had some very interesting comments in a piece published in the January 13th, 2010 edition of the Arizona Republic. A reader asked about the tax consequences on the debt forgiveness on three Arizona residences being sold as short sales. Two of the three properties were investment properties and the third was their primary residence and they wondered if they would have any taxes on the debt forgiven.
In Arizona, we have two issues to deal with in a short sale: deficiency judgments on the difference between the mortgage balance and a sales price lower than market value; and the tax consequences of the debt forgiveness on a property that is not your primary residence.
Mr. Combs, who is considered an expert in AZ real estate law explained that the seller of these three properties would "probably not" as "the amount of any debt forgiveness on a loan is generally taxable income, and the lender will send a Form 1099 to the Internal Revenue Service for the amount of the debt fofgiveness, debt forgiveness on loans used to purchase homes is generally not taxable income." (See complete article)
I kept reading, thinking Mr. Combs would go on to say that debt forgiveness on your AZ principal residence is not taxable income, as a result of the Debt Forgiveness Act of 2007. I expected him to say that the debt relief on the rental homes may be subject to taxes. He explains that the IRS has ruled that "there is no tax liability for debt foregiveness of non-recourse debt." He further explains that under Arizona law, "any loan used to purchase a home in generally non-recourse debt; that is, the homeonwer has no personal liability for the loan."
WOW! Most loans made to purchase Arizona residential real estate are non-recourse debt - on both personal residences and on homes purchased as investment property. This has huge implications for many investors who are forced to sell Arizona properties with short sales. I haven't seen anyone else address this issue of non-recourse debt being excluded from taxes on debt forgiveness. He also suggests that if your lender erroneously sends a Form 1009 indicating debt relief it can be corrected on your tax return. This is certainly an important point to remember and discuss with your tax preparer! I'm clipping and saving his column for future reference!