Double Whammy: Short Sale Incentives May Mean Tax Bill

You’ve heard the adage about not looking a gift horse in the mouth. But what if that “gift” comes with a hefty tax bill? That’s what can happen in the case of homeowners whose lenders offer them incentive payments to complete a short sale. Our reader “Mitch” wrote:

I received $3,000 in HAFA funds but also a $20,000 incentive from Chase to short sale. Both HAFA and the Chase incentive were listed on the HUD 1 and the amount due to Chase from the buyer was reduced by these incentives. Would the $20,000 incentive be taxable?

Or would the $20,000 be included in the 1099 deficiency amount?

I am not so worried about the deficiency as our home is in Arizona (anti-deficiency state) and also was covered in a 2009 bankruptcy so I believe we are not responsible for that as we did not reaffirm. But I am wondering about the $20,000 incentive. Thanks!

The HAFA funds that Mitch refers to are payments under the Home Affordable Foreclosure Alternatives program. In a previous post, I wrote that HAFA payments are generally not considered taxable by the IRS. But what about the other $20,000 from Chase?

That is considered taxable income, says Joann Koontz, CPA and an attorney with Koontz and Associates in Sarasota, Fla. She explains: “The incentives are taxable income because they are payments received from the lender, typically. This is not cancellation of debt income or ‘phantom income’ as it is sometimes called. This is real cash that they receive.” Short sale incentive payments are typically reported on Form 1099-Misc.

Unlike cancellation of debt income, however, taxpayers can’t exclude these amounts from their income if they are considered insolvent, or if debt was canceled under the Mortgage Forgiveness Debt Relief Act, Koontz explains.

“The MFDRA and insolvency exclusions do not apply to reduce or eliminate this income because those exclusions specifically apply to wipe out cancellation of debt income. The incentives are ‘ordinary income’ much like wages,” Koontz says.

And Mitch may misunderstand how the $20,000 incentive will be treated for tax purposes. Koontz says that they are typically treated as a payment to the seller – not the buyer. “Incentive payments are paid to the seller but generally can be used to reduce the seller’s contribution,” she explains. “I have never personally seen it where it went to reduce the amount the buyer pays.”

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Whether or not Mitch will receive a 1099 from Chase remains to be seen. Koontz reports that sometimes her clients receive these forms and sometimes they don’t. Of course, Mitch is supposed to report that income on his tax return regardless of whether the lender sends a 1099 or doesn’t.

As always, these tax issues can become complex so don’t hesitate to get advice from a tax professional.

Image: 401(K) 2012, via Flickr