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Washington State shorts sellers: an obvious problem with short sales, excise tax & Washington State’s position

Posted on Jan 11, 2009

UPDATE: If you’re looking for information on the short sale process in regards to real estate transactions in Washington State, you might want to read “The Anatomy of a Short Sale” instead. The post below is a response to a policy from the Washington State Department of Revenue on short sales that has since changed.

To tell this story effectively, I’m going to have to explain a few things – assuming that not all of you are up on the real estate vernacular of the day.

Excise tax: In the sale of real estate, Washington State charges a tax in the amount of 1.78% of the home’s value (to be paid by the seller). One would think that the easiest way to determine value on a property that recently sold would be to…I don’t know…maybe…look at the sales price?!?! But we’ll get to that in a minute.

Short sale:I would think that most of you would be familiar with this term, but in talking with friends and clients, I think that many are unclear of its true meaning. A “short sale” is different from a foreclosure or pre-foreclosure sale, in that the seller may be absolutely current on all of their payments and not in danger of foreclosure at all. That being said, these sellers are definately in a situation where they need to sell their home (think job transfer, medical leave or disability, divorce, etc). In a declining market where home values may have shrunk 10% in the last year, and closing costs for a seller are an additional 9% on top of that, many sellers just don’t have enough equity to cover the existing loans (or liens) against the property. Many may have had plenty of equity at one time, but they refinanced when values were high, borrowing against their home’s value to pay off car loans or credit card debt. Whatever their situation, these sellers are in a position where they have to sell their home in a declining market, and the value of their home is less than what is owed to the bank, so the sellers are “short” on the funds necessary to successfully close a sale through conventional means. In “short sale” situations, the purchase price and terms have to be approved by the underlying lien holders, since they are being asked to release their liens against the property without getting full satisfaction of the loans.

Which leads us to this: The Washington State Department of Revenue recently issued a letter to the President of the Escrow Association of Washington in regards to their position in assessing the amount of excise tax owed on a short sale transaction. The staggering amount of short sale transactions in the last 18 months has prompted a lot of questions and new legislation within the industry, and one of the questions that came up was regarding the assessment of Washington State’s excise tax (remember the 1.78% tax defined above?). To better explain the state’s response, let me give you an example:

Seller A and Seller B buy identical homes at identical times. Seller A put down $125,000 on a $450,000  purchase, while Seller B secured a zero down loan on a home of the same price. Two years later, the value of the homes that they purchased has dropped to $350,000, and both parties are in a position where they have to sell. Both homes sell for $350,000, but according to the Washington State Department of Revenue, one seller is going to pay more in excise tax. Any guess who?

Seller A bought his home for $450,000, but only got a loan for $325,000 because he put $125,000 down. He sold his house for $350,000, was charged 1.78% of the sales price as excise tax, so he paid the State of Washington $6,230.

Seller B bought his home for $450,000, and he got a loan for $450,000. He sold his house for $350,000, and was charged 1.78% of the home’s value as excise tax, so he paid the State of Washington $8,010. Seller B paid $1,780 more in excise tax than Seller A. Why is that?

Well, in the letter that they issued to the Escrow Association of Washington, the Department of Revenue stated that they understood the tax statute to allow them the right to charge excise tax against the amount originally owed by the seller when the amount owed on the property is greater than the sales price. The reason that this interpretation is even slightly plausible is because the language of the statute is purposely vague on how a home’s value is determined. It appears to me that it was intentionally vague for those that might try to avoid the tax by selling their $400,000 house to their daughter for $5,000, thus reducing their excise tax. While the statute is vague, I don’t think that it should be interpreted to mean that the state can tax sellers at their property’s peak value – further punishing residents that are already in a terrible situation by making them pay higher taxes for buying and selling at the least opportune times.

Many fear that sellers, when faced with the possibility of paying higher excise taxes, will simply let their homes slip into foreclosure (foreclosed properties happen to be exempt from excise tax). Good people, people that pay their mortgages on time, keep up their homes and their neighborhood, are going to vacate their homes entirely and force the bank to sell the property at a reduced value, further driving down the prices of the homes around them.

What’s even more inflammatory about this is that the Federal Government took steps in 2007 to prevent this from happening, enacting The Mortgage Forgiveness Debt Relief Act. This act cancels the taxes that would otherwise be owed by short sellers on the amount of debt that was forgiven on their primary residence. In the last month our own state has promised to increase the taxes owed to those that the Federal Government hoped to relieve.

Please contact your State Representative and ask them to enact and support legislation that would force the Department of Revenue to re-evaluate their position on this issue. I understand that excise tax is a necessary evil, but let’s make it subject to the sales price and quit trying to kick residents while they’re down.

UPDATE: The Department of Revenue has changed their tune after a meeting with Washington Association of Realtors. They’ve agreed to change their policy to tax based on the sales price on the home and not the amount owed on the property. I still think that it’s interesting the the Department of Revenue didn’t reach this conclusion on their own, but at least they were smart enough to realize that the issue wasn’t going to go away. Click HERE to read the full story.

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