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THE BOB-LAW BLOG

Short Sale vs. Bankruptcy

July 2011
Are you in California, under water, and over your head in debt? Then you may be wondering if bankruptcy is your only solution. The answer depends on your financial situation and every individual has a different set of circumstances. When making tough financial decisions as described in this article, you should consult with your attorney, financial advisor, and tax accountant to determine what solution works best with your situation.

If your only debt is your home loan(s) and your home is for 1 to 4 families, then you can consider short sale instead of bankruptcy. A short sale is the sale of your residence for less than the secured liens against it. It requires the agreement of all the lien holders. There are issues that can arise from a short sale such as a deficiency balance or tax consequences.

A deficiency balance is the difference between the lien amount and the sale price. If the lien holder does not agree to waive any deficiency balance, then they may be able to sue you for the amount of the deficiency. If you cannot afford to pay such balance, then bankruptcy may be appropriate. However, you should note that “money purchase” loans are considered non-recourse loans and are not permitted to obtain a deficiency judgment pursuant to California Code of Civil Procedure § 580b. If you are one of the many Californian’s who refinanced their loans and used equity to buy a new car or pay off bills, then your loan is no longer considered a “money purchase.”

You will also need to consider tax consequences. Generally, when a creditor (or lender) forgives a debt, the debtor will receive a 1099 Form for the cancelation of debt. The amount of the cancelled debt will be considered taxable income. If you file for bankruptcy relief and receive a discharge, then the cancellation of debt is not considered taxable income pursuant to Internal Revenue Code § 108(a)(1). Also, under the Mortgage Forgiveness Debt Relief Act of 2007, if the cancelled debt is for a qualified principal residence indebtedness and is discharged before January 1, 2013, then the cancellation of debt is not considered taxable income. A qualified principal indebtedness must meet the following conditions pursuant to IRC § 108(h):
    1. The loan subject to cancellation is a money purchase or acquisition loan as defined by IRC § 163(h)(3)(B); and
    2. The short sale is the result of the taxpayer’s financial condition; and
    3. The property subject to the short sale is the taxpayer’s primary residence pursuant to IRC §121, to wit, the taxpayer lived in the residence at least 2 years of the 5 years that immediately proceed the date of the short sale.

It is important to note, that if you receive a 1099 Form for cancelation of debt, it is incumbent on you, the taxpayer, to inform the IRS that the debt is excluded from income, if applicable, by filing Form 982 with your tax return.

The Law Office of Robert L. Buchler is a debt relif agency. We help people file for bankruptcy relief under the bankruptcy code. The information provided in this blog is not intended to be construed as legal advice or tax advice. If you would like a free confidential consultation with Attorney Robert L. Buchler, kindly call (209) 576-8404 or fill out our online contact form.

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California Code of Civil Procedure § 580b states in full:
“No deficiency judgment shall lie in any event after a sale of real property or an estate for years therein for failure of the purchaser to complete his or her contract of sale, or under a deed of trust or mortgage given to the vendor to secure payment of the balance of the purchase price of that real property or estate for years therein, or under a deed of trust or mortgage on a dwelling for not more than four families given to a lender to secure repayment of a loan which was in fact used to pay all or part of the purchase price of that dwelling occupied, entirely or in part, by the purchaser.
Where both a chattel mortgage and a deed of trust or mortgage have been given to secure payment of the balance of the combined purchase price of both real and personal property, no deficiency judgment shall lie at any time under any one thereof if no deficiency judgment would lie under the deed of trust or mortgage on the real property or estate for years therein.”

Internal Revenue Code § 108(a)(1) states:

"(a)Exclusion from gross income

(1) In general Gross income does not include any amount which (but for this subsection) would be includible in gross income by reason of the discharge (in whole or in part) of indebtedness of the taxpayer if—

(A) the discharge occurs in a title 11 case,

(B) the discharge occurs when the taxpayer is insolvent,

(D) in the case of a taxpayer other than a C corporation, the indebtedness discharged is qualified real property business indebtedness, or

(E) the indebtedness discharged is qualified principal residence

indebtedness which is discharged before January 1, 2013.”

Internal Revenue Code § 108(h) states:

"(h) Special rules relating to qualified principal residence indebtedness

(1) Basis reduction

The amount excluded from gross income by reason of subsection (a)(1)(E) shall be applied to reduce (but not below zero) the basis of the principal residence of the taxpayer.

(2) Qualified principal residence indebtedness

For purposes of this section, the term “qualified principal residence indebtedness” means acquisition indebtedness (within the meaning of section 163(h)(3)(B), applied by substituting “$2,000,000 ($1,000,000” for “$1,000,000 ($500,000” in clause (ii) thereof) with respect to the principal residence of the taxpayer.

(3) Exception for certain discharges not related to taxpayer’s financial condition

Subsection (a)(1)(E) shall not apply to the discharge of a loan if the discharge is on account of services performed for the lender or any other factor not directly related to a decline in the value of the residence or to the financial condition of the taxpayer.

(4) Ordering rule

If any loan is discharged, in whole or in part, and only a portion of such loan is qualified principal residence indebtedness, subsection (a)(1)(E) shall apply only to so much of the amount discharged as exceeds the amount of the loan (as determined immediately before such discharge) which is not qualified principal residence indebtedness.

(5) Principal residence

For purposes of this subsection, the term “principal residence” has the same meaning as when used in section 121.”

Internal Revenue Code § 163(h)(3)(B) states:

"(B) Acquisition indebtedness

(i) In general The term “acquisition indebtedness” means any indebtedness which—

(I) is incurred in acquiring, constructing, or substantially

improving any qualified residence of the taxpayer, and

(II) is secured by such residence.

Such term also includes any indebtedness secured by such residence resulting from the refinancing of indebtedness meeting the requirements of the preceding sentence (or this sentence); but only to the extent the amount of the indebtedness resulting from such refinancing does not exceed the amount of the refinanced indebtedness.

(ii) $1,000,000 limitation The aggregate amount treated as acquisition indebtedness for any period shall not exceed $1,000,000 ($500,000 in the case of a married individual filing a separate return).”

Internal Revenue Code § 121(a) states:

"(a) Exclusion

Gross income shall not include gain from the sale or exchange of property if, during the 5-year period ending on the date of the sale or exchange, such property has been owned and used by the taxpayer as the taxpayer’s principal residence for periods aggregating 2 years or more.”

Robert L. Buchler

Helping People make tough decisions on legal matters for 30 years.

THE BOB-LAW BLOG

Short Sale vs. Bankruptcy