If you're far behind in your mortgage payments, a short sale might sound like the perfect solution to avoid foreclosure. A short sale is when a homeowner sells the property for less than the total debt balance, and the lender agrees to accept the proceeds from the sale in exchange for releasing the lien on the property.
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." For example, say your lender approves you to sell your property for $300,000, but you owe $350,000. The deficiency is $50,000. Depending on state law and the terms of your short sale agreement, the lender might be able to 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 you through normal collection methods, like garnishing your wages or levying your bank account.
Or the lender might forgive the deficiency, in which case you could owe taxes unless you qualify for an exclusion or exception.
If the lender decides to forgive the deficiency, it will then usually report the amount of the canceled debt to you and the IRS on a 1099-C (Cancellation of Debt) form. Then, 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. You've received a cancellation of $50,000 worth of debt. 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 applies to debt that was forgiven in 2007 through 2025. It also applies to debt that's discharged after that time frame if a written agreement was entered into before January 1, 2026. 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.
As of December 31, 2020, you can exclude up to $750,000 ($375,000 if married and filing separately). Before this date, taxpayers could exclude $2 million ($1 million if you're married and filing separately). (To learn more, read Canceled Mortgage Debt: What Happens at Tax Time?)
The IRS also 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.