Donor's Remorse

Now that 2010 finally ended and Congress finally acted with respect to the estate and gift tax, a lot of gift and estate tax lawyers and their clients are trying to figure out how to reverse taxable gifts they made in 2010. It's a classic case of "it seemed like a good idea at the time." And it did.

This was the situation: In 2010 there was no estate tax. It was scheduled to return in 2011, but with only a $1 million exemption, as opposed to the $3.5 million exemption that existed in 2009, and at a 55% tax rate. To avoid a 55% tax on estates over the $1 million exemption, many estate and gift tax lawyers advised their clients to make taxable gifts in 2010. The reasoning was, the gift tax is only 35%. Better to save 20% in taxes by making a gift now than risking dying in 2011 or after.

But in January, Congress amended the tax code to provide for a $5 million exemption ($10 million for couples) and imposed only a 35% tax rate. Now, many of those people who made taxable gifts last year are realizing that they could have avoided any tax simply by waiting. For those with estates between $1 million and $5 million, this is certainly true. So they and their attorneys are scrambling to see if there is a way to undo the gifts they made last year.

This is a classic case of people ignoring the sage advice my tax professor gave in law school: Never do anything solely for the tax consequences. Do something that makes sense from a business standpoint and deal with the tax issue at that time. The people who made taxable gifts in 2010 did so solely in hopes of avoiding a possible estate tax.

Beware of Short Sales

I've addressed this topic before, but a client's situation brings it to the fore again. If you are upside down in your mortgage and thinking about a short sale, BEWARE! My clients had a real estate agent negotiate a short sale with their lender, who holds both a first and a second mortgage on their property. The combined mortgages are about $185,000 and, according to the agent, the property is worth about $90,000. The agent has presented a buyer for $90,000 and the lender has agreed to a short sale. So everything is great, right?

Not really, because the short sale agreement (written by the lender, of course) starts out by saying that the lender reserves its right to seek a deficiency against the borrowers (my clients). My clients are expected to contribute $8,000 in cash at closing (above the sales price, so this comes out of their pockets) and must give the lender a promissory note for another $7,000, payable at zero per cent interest for five years. At a minimum the short sale is costing my clients $15,000.

What my clients, and what most people doing a short sale, thought they were getting is a release from all liability to the lender upon sale for $90,000, plus the promissory note. They didn't realize they had to pony up cash, nor did they realize that all the lender is agreeing to do is to release its mortgages. The lender can still seek a deficiency against my clients for $95,000, the difference between the two mortgages ($185,000) and the sales price ($90,000).

And here's one last kick in the head. If the lender agrees to release my clients from the deficiency, the lender will undoubtedly file a form 1099 with the IRS, miscellaneous income, and my clients will get a hefty tax bill for the forgiven debt. Debt that is forgiven is income and you can be taxed on it.

Before you agree to a short sale, make sure you understand all of the ramifications of the deal.