Tax Consequences of a Short Sale

In a short sale, a home seller looks for a home buyer that offers to purchase a home for an amount less than the outstanding mortgage debt. If the mortgage servicer or lender bank agrees to a short sale, the mortgage debt may either be eliminated or reduced. The U.S. Internal Revenue Service (IRS) considers any eliminated debt as ordinary income to the seller. As this income is considered as ordinary income, this is subject to taxation. However, here are some tax reliefs available as a result of a short sale:

Tax Exemptions

If the seller – the mortgage debtor – in a short sale files for bankruptcy or she can prove that her liabilities are more than her assets, then there can be no federal taxes as a result of the short sale income. If the mortgage debtor holds a non-recourse loan, the mortgage servicer or lender bank cannot collect assets from the debtor that are not pledged to secure the loan. In this case, the proceeds of the short sale may be subject to taxation but this does not include the canceled short fall of the original mortgage debt.

Debt Forgiveness

The Mortgage Debt Relief Act of 2007 provides tax relief on the income gained as a result of a short sale. Under the Mortgage Debt Relief Act, the property sold through short sale has to be the seller’s principal home and the balance of the loan must be $2 million or less; and in the case of a married person filing a separate tax return, the limit is $1 million. Short sales covered under the Mortgage Debt Relief Act applies to those transacted from 2007 to the end of 2012.

Report to the IRS

Upon the completion of the short sale transaction, the lender provides Form 1099-C to the seller. This form specifies the appraised value of the property sold under short sale and the amount of the debt canceled. This Form 1099-C provided by the lender must be checked by the debtor, seeing to it that the information provided is correct. The debtor, not the lender, has the responsibility to report to the IRS the amount of the debt canceled. Upon failure to inform the IRS about the amount of the debt canceled, the IRS will consider the debt canceled as ordinary income and can penalize the debtor or short sale seller for unpaid taxes.

Additional Tax Liability

Noticed that the Mortgage Forgiveness Debt Relief Act is only applicable to tax owed to the federal government. As a result of the short sale, there might be additional taxes due to the state where you reside.

This article serves as a guideline only as we are not tax advisors. For detailed and specific advice about tax consequences of a short sale, do contact an accountant or tax advisor.