If you're far behind in your mortgage payments, a short sale might sound like the perfect solution to avoid foreclosure. But if you complete a short sale, you could be subject to an income tax hit.
Read on to learn more about when short sales result in tax liability and when you're exempt from paying such taxes.
A short sale is when a homeowner sells his or her home for less than the total debt balance remaining on the mortgage and the lender agrees to accept the proceeds from the sale in exchange for releasing the lien on the property. Short sales are one way for borrowers to avoid foreclosure.
After a short sale, the lender might decide to come after you for a deficiency judgment. Or it might forgive the deficiency, in which case you might owe taxes.
In a short sale, the sale price is “short” of the amount you owe to the mortgage lender. The difference between the total debt owed and the sale price is the “deficiency.”
Example. Say you're approved by your lender to sell your property for $300,000, but you owe $350,000. The deficiency is $50,000.
In many cases, the lender can seek a personal judgment against you after the short sale to recover the deficiency amount. Generally, once a lender gets a deficiency judgment, it may collect this amount—in our example, $50,000—from the borrower through normal collection methods, like garnishing the borrower’s wages or levying the borrower’s bank account.
On the other hand, the lender might choose to forgo pursuing a deficiency judgment, forgive the deficiency amount, and issue you a 1099-C (Cancellation of Debt) form instead.
If a short sale results in a deficiency, but the lender decides not to come after you for payment and forgives the debt, this means you're no longer under an obligation to repay the lender. The lender is then usually required to report the amount of the canceled debt to you and the IRS on a Form 1099-C. If this occurs, you might have to include the forgiven amount as income for federal tax purposes. (That additional income might also affect your state taxes.)
Example. As in the case above, let’s say you complete a short sale by selling your property for $300,000, but you owe the lender $350,000. The deficiency is $50,000. If the lender decides not to try to obtain a deficiency judgment and issues a 1099-C instead, then you have received a cancellation of debt in the amount of $50,000. This amount is generally considered taxable income to you.
You might be able to escape tax liability for a short sale deficiency if you can meet the requirements under the Mortgage Forgiveness Debt Relief Act of 2007. This Act, and it's various extensions, allows taxpayers to exclude certain types of forgiven debt from their taxable income, as long as the forgiven debt was used to:
This exclusion only applies to debt that was forgiven in 2007 through 2020, or to debt that is discharged after that if a written agreement was entered into before January 1, 2021. But the exclusion doesn't apply to loans for other kinds of real estate, like second homes, or loans not used for real estate, like if you took out a home equity loan and used the proceeds to pay off credit card debt.
You can exclude $1 million of forgiven debt, or $2 million if you are married and filing a joint tax return. (To learn more, read Canceled Mortgage Debt: What Happens at Tax Time?)
The IRS provides a few exceptions and exclusions to the general rule that canceled debt is included in the gross income of the taxpayer. They include:
Tax laws are complicated. If you received a 1099-C form indicating your lender forgave all or part of your mortgage debt, or if you’re considering completing a short sale or deed in lieu of foreclosure that has tax implications, talk to a tax attorney or tax accountant to get advice specific to your circumstances.
If you have questions about how foreclosure works, need help applying for a loan modification, or want to learn the pros and cons of completing a short sale or deed in lieu of foreclosure, talk to a foreclosure lawyer. A HUD-approved housing counselor can also provide you with loss mitigation information.