Phantom Foreclosure
What constitutes a primary residence?
I have lived in my town house for the past 4 years. I am considering buying a new home and renting my townhouse out. If i cant find a suitable renter or if my renter leaves within the 6 month lease I might be forced to short sale or foreclose. I have heard of the law “if you lived in your home 2 years within the 5 years you sold or foreclosed” you can still claim it as a PRIMARY RESIDENCE. This way I would not have to pay taxes on the phantom income I may generate from a short sale or foreclosure. My townhouse is way upside down and it would never sell for what I owe. My state is Arizona and it is a NON RECOURSE state. If I “were” to sell or foreclose it would be within a year after I moved which I would still be within the 2 year/5year window of a primary residence. Can anyone clarify this for me
I believe that you’re referring to the tax law that allows for an exclusion of gain for the sale of a person’s PRINCIPAL RESIDENCE (the IRS uses the term “principal residence” instead of “primary residence”). This is available for people who have owned the residence and used the home as their principal residence for at least 2 out of the last 5 years (the ownership and the use tests don’t necessarily have to be done concurrently, and the home doesn’t need to be the principal residence at the time of sale in order for the test requirements to be met).
This provision probably doesn’t apply to you because it is an exclusion of capital gains from the sale of the home, and you are unlikely to have a gain. Whether or not you have a gain is NOT directly related to your mortgage balance. A gain occurs if you sell the townhome for more than the tax basis. (see your tax advisor if you want to know exactly what your tax basis in your townhome is.)
However, if you short sell, the bank is forgiving part of the loan. If the townhome is not your principal residence at the time of the short sale, you will have to pay tax on the debt forgiven. And this applies even if you have owned the home and used the home as your primary residence for at least 2 of the last 5 years. However, if the townhome were your principal residence at the time of a short sale, the debt forgiven by your lender would not be taxable (a $2 million cap is in place, but I don’t think that would apply).
So if you’re thinking about a short sale, it’d be much better if this occurred while you were using the townhome as your principal residence, or any debt forgiven would be taxable.
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