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Taxes might have to be paid in the wake of short sale

Dear Benny: I am in the process of preparing my income taxes and heard that I may have to pay a tax on the monies that my lender canceled when I sold my house via a short sale.

Is this correct? –Theresa

Dear Theresa: I have to give you a good lawyer’s response: It depends. Usually under the tax laws, if your debt is canceled or forgiven, that is taxable income to you.

However, Congress thought this was absurd: You lose a house by foreclosure or short sale and, to add insult to injury, you have to pay tax on this phantom income.

Accordingly, under the Mortgage Forgiveness Debt Relief Act of 2007, you may be able to exclude up to $2 million if that debt was on your principal residence.

If the debt was on a second home or an investment property, then you are out of luck. The amount that was forgiven, or canceled, is taxable income to you.

If your canceled debt was on a refinanced loan, the law is murky. If you used the refinance proceeds to substantially improve your house, then there is no tax to pay.

But if you used those proceeds for other purposes — regardless of how significant the investment may have been — the cancellation creates a taxable event for you.

The Internal Revenue Service has an excellent, free publication on this topic, called “Canceled Debts, Foreclosures, Repossessions and Abandonments.”

It is Publication 4681 and will soon be published at the following link on the IRS website — irs.gov/pub/irs-pdf/p4681.pdf — or by calling 1-800-TAXFORM.

Dear Benny: I’d like to know if a deed-in-lieu of foreclosure is possible in the following situation:

I am the sole mortgage holder on our house. I listed it as a short sale for a year to no avail. I am recently divorced, but my ex can reside in the house.

Both of us are on the deed.

In our divorce settlement agreement, because the house mortgage is in my name only, he must allow me to try to sell it. I spoke with the bank and a deed-in-lieu is an option I would like to pursue.

However, does my ex husband need to be involved with any of the official documents in the deed-in-lieu process?

I guess what I am asking is although I am able to pursue selling however I choose, would a deed-in-lieu be considered the same thing? –Lisa

Dear Lisa: A deed-in-lieu is a process whereby your mortgage lender agrees to take back the house instead of — i.e., in lieu of — spending the time and money foreclosing on the property.

Have you discussed the situation with your ex-husband?

Keep in mind that, though you are the only one on the mortgage, he still has an ownership interest in the property and will have to sign the deed along with you.

If you believe you can sell through a short sale, whereby you will not get any of the sales proceeds, I believe you would have the same right to give the deed back to the bank.

Talk with your divorce lawyer to confirm that you have the right to do a short sale. If so, then I think the deed-in-lieu will also fly.

Benny Kass is a practicing attorney in Washington, D.C., and Maryland. No legal relationship is created by this column. Questions for this column can be submitted to benny@inman.com.

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