Sometimes, homeowners facing foreclosure opt to go the short sale route. In a nutshell, a short sale is an agreement between the homeowner and the mortgage lender, whereby the lender allows the homeowner to sell the home for an amount less than what's actually owed on the loan. But if you complete a short sale, you might face tax consequences.
In a short sale, the difference between the total mortgage debt and the sale price is the "deficiency." For example, say your lender approves a short sale in the amount of $300,000, but you owe $325,000 on the loan. The difference—$25,000—is the deficiency.
In many states, the lender can seek a personal judgment against you after the short sale to recover the deficiency amount. The lender can also choose to forgive (cancel) this amount.
If your mortgage lender forgives the deficiency after a short sale, you might owe federal taxes on the forgiven amount because it's considered income by the IRS. (That additional income might also affect your state taxes.) The rationale behind this is that a borrower who is relieved from the obligation to repay a debt has, in essence, received income. For a homeowner struggling to make ends meet, the prospect of owing money to the IRS makes a short sale much less inviting.
You might be able to exclude all or a portion of the forgiven amount from your income under the Qualified Principal Residence Indebtedness (QPRI) exclusion, if all of the following requirements are met:
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). Debt forgiven on second homes, vacation homes, and rental properties doesn't qualify for the exclusion. Additionally, canceled debt on credit cards and auto loans doesn't qualify.
There are several instances when the IRS does not require canceled debt to be treated as income:
1. Debts discharged in bankruptcy are not treated as taxable income.
2. If at the time the debt is canceled the taxpayer is insolvent, he or she is not required to report the forgiven debt as income. A person is considered insolvent if his or her total debt exceeds the fair market value of all his or her assets.
3. The third exception to the rule that canceled debt is taxable involves certain farm debts. If the debt was incurred directly as a result of operation of a farm, the taxpayer derived more than half his income from the three prior years from farming, and the loan is owed to a person or entity that is regularly engaged in the business of lending money, canceled debt is generally not considered taxable income.
4. Nonrecourse debt which is forgiven is not treated as taxable income. (Nonrecourse debt is a loan where the borrower is not personally liable for repayment.)
A short sale negotiation can be very time consuming, and any homeowner considering a short sale is advised to consider the tax implications of a short sale before finalizing the deal with the lender. For more on potential problems with doing a short sale, see Risks of Using a Short Sale to Avoid Foreclosure.
Also, 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.