Frustrated-young-couple-financesA short sale is when someone sells a house for less than it is worth and less than the debt against the property in an effort to get out from under the mortgage. Short sales are one way to avoid a foreclosure, which looks worse on one’s credit report than the foreclosure. Furthermore, a short sale avoids the legal costs tacked onto the debt that come with foreclosure, reducing the debt someone will owe after the house is sold.

States like California are changing their laws in an effort avoid bank foreclosure problems such as the cases where someone bought a house in a short sale only to have the bank foreclose or auction the property a few months later. California is doing this by prohibiting the dual tracking of house foreclosures and short sales. Banks have responded by canceling the foreclosure when there is a short sale. If the short sale falls through, they can restart the foreclosure process. Hawaii does not yet have a law like this on the books, but Hawaii often follows California’s lead.

A federal law that will affect short sales in Hawaii is the expiration of the law affecting short sale debt forgiveness. For short sales through the end of 2013, the difference between the outstanding mortgage debt and the short sale price of the property was a debt that could be forgiven without any income taxes being owed on the forgiven debt. However, this provision expires December 31, 2013. For any short sales after this date, as a part of the effort to avoid foreclosure, the unpaid mortgage debt after the foreclosure may be taxable income again.

If you are considering a short sale, contact us to properly plan for the tax implications of a short sale and outstanding debt that may be forgiven. Unless Congress changes the law and extends the expired provision, you will need to plan on the higher income tax bill due to the forgiven debt unless filing for bankruptcy. Unlike other forms of debt, recent tax debt is not discharged in bankruptcy, regardless of your circumstances.  Note that you may be able to specifically avoid tax consequences by filing for  bankruptcy before conducting your short sale.