Many 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 mortgage lender allows the homeowner to sell the home for an amount less than what is actually owed on the mortgage loan.
In a short sale, the difference between the total debt and the sale price is the “deficiency.” For example, say your lender approves a short sale in the amount of $200,000, but you owe $225,000 on the mortgage. 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 this amount.
If your mortgage lender forgives the deficiency after a short sale, you may owe taxes on the forgiven amount because it's considered income by the IRS. 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 may be able to exclude all or a portion of the forgiven amount from your income under the federal Mortgage Forgiveness Debt Relief Act of 2007, if all of the following requirements are met:
Up to $2 million of forgiven debt qualifies for the exclusion. However, the maximum exclusion for married taxpayers filing separately is $1 million.
Debt forgiven on second homes, vacation homes, and rental properties does not qualify for the exclusion. Additionally, canceled debt on credit cards and auto loans does not qualify.
There are several instances when the IRS does not require cancelled 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. Non-recourse debt which is forgiven is not treated as taxable income.
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.