Taxes Nightmare For Homesellers Few Understand

The foreclosure mess due to the economic downturn has left many homeowners facing devastating taxes, even after they sell a house in a foreclosure or short sale or one that is underwater, so they earn little, nothing, or sell the home at a loss.
07/09/2013 04:51 pm ET Updated Sep 08, 2013

The foreclosure mess due to the economic downturn has left many homeowners facing devastating taxes, even after they sell a house in a foreclosure or short sale or one that is underwater, so they earn little, nothing, or sell the home at a loss. But many homeowners don't know about this, and this could affect their decision whether to sell or not. That's what happened to me, and here's why a former homeowner could be facing an unexpected big tax bill which is difficult to pay and can't be discharged in a bankruptcy for three years or otherwise for ten years. This is the way the process works.

When a homeowner sells a home, he or she has six months to put any proceeds into a new home or face "capital gains" taxes on the difference between the sale and purchase price, less exclusions for the cost of the sale and the individual or couple's exemption of $250,000 to $500,000.

To qualify for the exchange, a homeowner has to file with a real estate firm certified to handle 1031 Haven Exchanges within 45 days of the sale and buy a property where the equity in the new house is at least as much as in the property that was sold. The idea of the exchange provision is to encourage continued home ownership and investment.

Now this arrangement can be fine for a homeowner who is financially secure and able to avoid these taxes by buying a new home, or is in the happy position of making a profit on the sale of a home, and can thus afford the taxes on the increase in value gained from a sale. But what many homeowners and many others are unaware of is that individuals who are experiencing hard times and are forced to sell a home due to a default, foreclosure, or short sale, can end up with a big tax bill they can't afford to pay because of their difficult financial situation -- even if they have earned nothing or very little from the sale. Then, they have to wait for three years after filing their tax return if they are seeking a bankruptcy to start again. Or if they file for bankruptcy before this three year period, the tax bill remains for 10 years. While it is sometimes possible to arrange for an offer and compromise to discharge a tax bill for a percentage of the total amount, it commonly takes at least a year to arrange this, while interest and penalties add up, and often these offers are rejected.

Meanwhile, after about three to four months of notices, the IRS and state agency can readily collect by tapping bank accounts, wages, or other assets after notifying the debtor of its intentions, unless the debtor is deemed insolvent, so there is nothing to collect. But then the IRS and state agency will simply wait until the debtor has money again.

Thus, instead of being able to start over through a regular bankruptcy, an individual with a big tax bill is stuck in a limbo that can last up to 10 years, while other creditors can circle and attack at any time up to seven years from the debts owed to them, unless a bankruptcy is filed.

Likewise, anyone who was once successful but loses a job or business can face a big tax bill the following year and face a similar conundrum in deciding whether to go bankrupt or not. But compounding the problem for homeowners is that few realize the tax consequences of selling a home which is facing foreclosure or underwater. Instead, many wrongly think a short sale will be a good way out, especially when urged by real estate agents who will get a commission on such a sale. But if the home sells for $500,000 or more for an individual, $750,000 or more for a couple, and the home increased in value more than $300,000 from when it was purchased, there will be a tax on the difference, even if the sale resulted in no or very little profit to the seller, due to paying off the mortgage or equity line on the house. While the seller may have had the advantage of this borrowed money in good times, now with a reduced income, commonly due to a loss of job or business, the individual is still stuck with big tax bill he or she can't pay or discharge like other debts in a bankruptcy to begin again.

However, many homeowners aren't aware of these tax consequences of a home sale, and many real estate agents don't know or don't tell their clients, so many sellers think they are only taxed on any profits like regular income, reduced by regular deductions and losses. They don't understand the complicated formula used to assess what they gained from the sale, as I experienced myself, resulting in a big tax bill they can't afford under their present circumstances. Had they known, they might not have sold their house and might have tried to hold onto their house as long as possible before being forced out by a foreclosure, including filing for a bankruptcy just before the foreclosure sale to prolong the process for about six more months.

But due to the complexity of many tax and bankruptcy provisions, many people not in these fields don't realize the problem or find it difficult to understand, even when explained. For example, one journalist writing about housing and mortgage issues seemed to think excluding the first $250,000 in profit from taxes was all the tax forgiveness necessary. Even after I explained the problem was due to inflation in the value of my house after I lived their 17 years, she wrote back: "I still don't see this as a widespread problem. Most people would be thrilled to have a house worth $500k more than they paid for it, with half of that gain being tax free." Sure, that might be fine for someone earning good money for a job or business - but not for someone who was now struggling due to difficult economic conditions. The journalist just didn't get it, like many others who don't understand how such a tax bill can make it more difficult for someone who was once successful get back on their feet after experiencing hard times.

The potential numbers of people in this situation are huge. For example, over 12 million homeowners faced losing their homes to foreclosure or selling underwater homes, commonly due to loss of jobs or business. Plus there are many millions more who are suffering due to lost jobs or lost businesses, and in many cases they are facing a default or underwater home, too.

Thus, anyone selling a home, as well as people experiencing the loss of a job or business, need to understand the tax consequences they face, so they can better plan what to do about the tax bill that may come in the future. And anyone who knows anyone in this situation might let them know about the potential tax bills they may face, too.


Gini Graham Scott, Ph.D. is the author of over 50 books with major publishers and has published 30 books through her own company Changemakers Publishing and Writing. She writes books and proposals for clients, and has written and produced over 50 short videos through her company Changemakers Productions. Besides, LIVING IN LIMBO her latest books include: TRANSFORMATION: HOW NEW DEVELOPMENTS IN SCIENCE, TECHNOLOGY, BUSINESS AND SOCIETY ARE CHANGING YOUR LIFE and THE BATTLE AGAINST INTERNET PIRACY