Short sales are more and more common. If properly structured, the favorable tax consequences of an AV or BVO home sale process should still be available in a short sale. However, companies must address other issues that arise, such as careful scrutiny of lender letters approving the short sale and disclosure of relocation benefits to the lender.
The Full Story:
Today’s tax quote: “[T]here is nothing wrong with a strategy to avoid the payment of taxes. The Internal Revenue Code doesn’t prevent that.” William H. Renquist
One common strategy for avoiding tax on the relocation of an employee is to take advantage of the favorable treatment of relocation home sale programs in which the employer purchases the employee’s home, and then sells it in a separate, independent, sale. In such programs, costs of sale are not taxed as wages to the employee, avoiding gross up, and the employer avoids employment taxes on those amounts as well. See Rev. Rul. 2005-74.
A frequent question these days, however, is whether conducting a short sale through use of the Amended Value (AV) or Buyer Value Option (BVO) home sale process would compromise the tax qualification of the home sale program.
Although as with most questions involving home sale programs the answer is not absolutely clear, if done properly it is perfectly possible for an AV or BVO to involve property that is the subject of a short sale.
Assume that the relocation company (RMC) has determined that the transferee is likely in a negative equity situation. The AV or BVO process could proceed as it does ordinarily, except that the transferee would have to seek lender approval to reduce the debt to the proceeds of the short sale. (If a company agrees to pay negative equity itself, or purchases the house for an amount insufficient to pay off mortgage liens, then that amount is wage income to the employee, and is also an unacceptable cost to the company in most instances).
A debt reduction through a short sale would ordinarily require submission of a “hardship letter” to the lender, together with financial data showing the transferee does not have other assets from which he or she can satisfy the debt. (Note that as a part of this process, relocation benefits should be considered assets, and fully disclosed, including the fact that the transferee’s company will be paying homesale closing costs). It would also typically include showing the lender a bona fide, negotiated offer to purchase that is represented as the best offer that can be obtained, or appraisals acceptable to the lender if the company intends to make an appraised value offer in the AV situation.
Generally, these steps cause a delay inherent in the process, which may be substantial, and an outside buyer identified through the AV or BVO process may not wait forever. Further, no completion of the transactions is possible (either the purchase from the employee or the sale to the outside buyer) until the lender has agreed to reduce the debt, which will take the form usually of an approval letter. This amount of tying of the two sales together (since both are dependent upon the debt reduction) adds to the risk that IRS will consider them not to be separate, independent sales, and will hold the costs paid by the company to be taxable to the employee.
However, these potential objections can be overcome if the transactions are handled properly. Nothing in the IRS-approved home sale procedures prevents the RMC from inserting in its contract with the employee a requirement that the employee furnish an acceptable form of an agreement by the lender to accept less than the full amount of the mortgage debt owed. That is not a contingency that relates to the outside sale; it is a contingency relating solely to the sale between employee and RMC that prevents the RMC from becoming liable for debt beyond the value of home. It is no different in essence from the provision typically found in purchase contracts requiring the employee to pay off any negative equity.
The RMC’s contract with the outside buyer always contains a contingency that the sale is dependent upon the RMC successfully purchasing the home from the employee. If the lender does not provide an acceptable debt reduction agreement to the employee, the first sale will not take place, and the RMC is absolved of any requirement to complete its own sale.
Consequently, if an AV or BVO is conducted as a short sale, and both contracts are executed before lender approval but with the clauses noted in the contracts, the transactions are not fundamentally different than any other qualifying home sale. The transferee simply has to arrange to pay off his or her negative equity, or get it eliminated by the lender. The tax consequences should be the same. Note, however, that there is no authority relating to this issue.
Although there is a good argument for favorable tax treatment if the transactions proceed as described above, if neither contract will be executed until the lender approves the short sale (that is, even the contract risk is deferred until the short sale is approved), there is a much stronger argument that the two sales are tied together, and that the first was contingent on the second. Nor should entering into a binding contract with the transferee be delayed waiting for lender approval; that will strongly suggest that the purchase from the employee is inextricably linked to a successful outside sale.
Some companies will not do relocation home purchases if a short sale is involved, because of the inevitable delays, the additional paperwork, the risk that the lender will at some point rescind its approval, or try to change the terms, or seek additional money, and the additional tax risk. And indeed, lender approval letters must be very carefully scrutinized to make sure the lender has not included any sort of ability to change its mind, and companies must make sure they are comfortable that their policies and procedures require that all relevant facts, financial and otherwise are being disclosed to the lender. If a lender concludes that it has been defrauded in some way in the process, it may well seek to overturn its approval, or seek to recover funds.
However, if proper procedures are followed relocation home sales can be done as AV’s or BVO’s, or indeed, as guaranteed buyouts. Although the risks are higher to the company, many companies are finding it necessary to take on those risks as more and more potential transferees face negative equity situations that cannot be resolved without a short sale. As noted, a properly structured AV or BVO program should be effective to accomplish a short sale without negative tax consequences. Or as Justice Renquist puts it, “the Internal Revenue Code doesn’t prevent that.”
Posted by Peter K. Scott