If your lender agrees to a short sale or to accept a deed in lieu, you might have to pay income tax on any resulting deficiency. In the case of a short sale, the deficiency would be in cash and in the case of a deed in lieu, in equity.
Here is the IRS's theory on why you owe tax on the deficiency: When you first got the loan, you didn't owe taxes on it because you were obligated to pay the loan back (it was not a "gift"). However, when you didn't pay the loan back and the debt was forgiven, the amount that was forgiven became "income" on which you owe tax.
The IRS learns of the deficiency when the lender sends it an IRS Form 1099C, which reports the forgiven debt as income to you. (To learn more about IRS Form 1099C, read Nolo's article Tax Consequences When a Creditor Writes Off or Settles a Debt.)
Tax liability for some loans secured by your primary home. In the past, homeowners using short sales or deeds in lieu were required to pay tax on the amount of the forgiven debt. However, the Mortgage Forgiveness Debt Relief Act of 2007 (H.R. 3648) changed this for certain loans during the 2007 through 2017 tax years, as well as debt discharged in 2018 if there was a written agreement entered into in 2017.
The law provides tax relief if your deficiency stems from the sale of your primary residence (the home that you live in). Here are the rules:
The insolvency exception to tax liability. If you don't qualify for an exception under the Mortgage Forgiveness Debt Relief Act, you might still qualify for tax relief under an exception or exclusion. For example, if you can prove you were legally insolvent at the time of the short sale, you won't be liable for paying tax on the deficiency.
Legal insolvency occurs when your total debts are greater than the value of your total assets (your assets are the equity in your real estate and personal property). To use the insolvency exclusion, you'll have to prove to the satisfaction of the IRS that your debts exceeded the value of your assets. (To learn more about using the insolvency exception, read Nolo's article Tax Consequences When a Creditor Writes Off or Settles a Debt.)
Bankruptcy to avoid tax liability. You can also get rid of this kind of tax liability by filing for Chapter 7 or Chapter 13 bankruptcy, if you file before escrow closes. Of course, if you are going to file for bankruptcy anyway, there isn't much point in doing the short sale or deed in lieu of, because any benefit to your credit rating created by the short sale will be wiped out by the bankruptcy. (To learn more about using bankruptcy when in foreclosure, read Nolo's article How Bankruptcy Can Help With Foreclosure.)
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