How Does a Short Sale Affect Your Taxes?
Even though the information on this web page is provided by a qualified industry expert, it should not be considered as legal, tax, financial or investment advice. Since every individual’s situation is unique, a qualified professional should be consulted before making financial decisions.
From this article you will learn about short sale tax implications you need to keep in mind when short selling your property. You will also find out if short sale tax consequences are different from the ones of other options of avoiding a foreclosure and from the foreclosure itself.
In fact, “how does a short sale affect my taxes?” is a frequent question that I hear from homeowners coming to me for help with processing their short sale. And I will gladly share the answer with you.
Note: if you are also interested in other articles about how a short sale works for the seller, you are welcome to read my other guides:
- A-to-Z Short Sale Guide for Homeowners
- Step-by-Step Short Sale Process for Home Sellers
- Short Sale vs Foreclosure vs Deed in Lieu
- How Long Does a Short Sale Stay on My Credit Report and How Bad Does it Hurt It?
- What Does a Short Sale Negotiator Do for the Seller?
This article is NOT meant to serve as tax advice. It is strongly suggested to contact and consult with a licensed tax professional prior to doing a short sale.
Let’s start with a short video from our general Short Sale Guide explaining the basics of tax implications of a short sale.
What Is the Deficiency From a Short Sale?
When a lender grants you approval to sell your home via short sale, they are agreeing to accept an amount of money that is less than what you owe on the mortgage balance. This is a common way to avoid foreclosure.
Here’s how it looks:
Bob has a mortgage balance of $300,000, but the as-is value of his home is $250,000. He is behind on mortgage payments and lists the house for sale through a short sale. The lender approves the sale of Bob’s property for $250,000, leaving $50,000, which he will not have to pay back at settlement.
In the example above, the $50,000 (difference between what was owed and what the home sold for) is called the deficiency.
Deficiency is just another word for “canceled debt.”
Is the Cancelled Debt Taxable and Reported to IRS?
The answer to this varies from situation to situation (we will go over them some of them in the next section). However, yes, it definitely can be taxable.
Your lender reports the cancelled debt through a 1099-c form to the IRS, after the short sale closing occurs.
According to the IRS, any debt you owe that is canceled, discharged, or forgiven, becomes taxable income to you.
Here is how the typical 1099-C IRS form is laid out:
- Name of the creditor in which the debt has been discharged, canceled, or forgiven.
- Debtor’s name and information. Your information would go in this section.
- Date the incident occurred. So, this would be the home’s settlement date.
- The amount of money that was discharged.
- The next couple of questions have to deal with the estimated market value of the property, etc.
Can I Escape Tax Liability From a Short Sale?
Avoiding the responsibility of short sale taxes after the cancellation of debt is possible, but solely dependent on your specific situation.
As stated earlier, this is NOT meant to serve as tax advice. It is strongly suggested to contact and consult with a licensed tax professional prior to doing a short sale. But here are some of the potential ways to overcome the short sale tax liabilities to give you general understanding:
Mortgage Forgiveness Debt Relief Act of 2007
This legislation lets certain taxpayers exclude types of discharged debt from their taxable income.
Here is the caveat:
The forgiven debt must be used to buy, build, or substantially improve a principal residence OR to refinance debt incurred for those purposes.
The key word above is principal residence. This IRS rule does not apply to other types of real estate loans or loans that are unrelated to real estate.
Here are some loan types the Mortgage Forgiveness Debt Relief Act will not apply to:
- secondary home loans
- investment property
- credit card debt
- car loans, and the list goes on….
In addition, the exclusion only pertains to debt that was discharged in 2007 through 2020. If debt is forgiven after that time frame, then a written agreement must have been entered into before January 1st, 2021.
A non-recourse loan is a loan that is secured by the property itself, but for which you are not personally liable.
The lender’s collateral is limited to only the amount of the property. So, if you sell the home through a short sale, the lender cannot come after the cancelled debt and hold you personally liable.
Some Debts That Are Related to Farms
These can vary and include certain loan packages from the USDA and other related lending services for this niche field.
Debt Discharged in Bankruptcy
A bankruptcy discharge releases the debtor from personal liability for certain specified types of debt.
There are several different types of bankruptcies. Extensive explanations and variables go along with each.
Insolvency is when a person is in a state of financial distress and unable to pay their bills. More specifically, when someone claims insolvency, they are proving to the IRS that their liabilities outweigh their assets.
Is Taxable Deficiency Judgement a Drawback of a Short Sale?
In general, the answer to this question is “yes”. However, it is important to keep in mind that the other potential options, such as deed in lieu and foreclosure, will result in possible taxation on the cancelled debt as well, just like a short sale.
An option such as bankruptcy may not have similar tax results, but can be more damaging to your credit and overall financial status. So, potentially paying taxes on the cancelled debt may be way more beneficial overall.
Important Key Points to Remember
- It is highly suggested to consult a licensed tax professional before performing a short sale. They will be able to answer all of your questions in depth, as well as provide you with consultation and advice.
- In a short sale in real estate, the lender allows the borrower to sell for less than what is owed on the mortgage balance. The difference between those two numbers is called the deficiency, or canceled debt. Think of the example of Bob in the beginning of the article.
- The cancelled debt in a short sale is reported by the bank to the IRS, with an IRS form 1099-C.
- Escaping the tax liability from a short sale is possible and will vary by situation. The possible ways to avoid paying the levy include the Mortgage Forgiveness Debt Relief Act of 2007, non recourse loans, some debts that are related to farms, debt discharge in bankruptcy, or claiming insolvency.
- In most cases, a short sale is the option that allows to avoid foreclosure with lightest overall financial damage.
If after reading this article you have decided that a short sale could be the best possible option in your situation, you will likely be interested in having your short sale professionally processed by a short sale processing company whose services are free of charge for home sellers. To get consulted by one of the most reliable short sale processors in your area, you are welcome to fill out our form.