Short sales can be a godsend or a nightmare for struggling homeowners. The sweet side of such a deal is that your mortgage lender allows you to sell your property for less than your outstanding mortgage balance, typically for fair market value. The downside is that, under some circumstances, the Internal Revenue Service considers that the difference is taxable income.
If your home is worth $250,000 and your mortgage balance is $275,000, your lender might consent to a $250,000 short sale and agree not to pursue you for the $25,000 difference. The IRS takes the position that your lender is actually giving you this money. It paid the $25,000 on your behalf, so if you don’t pay it back, it’s money you didn’t have before you took out the mortgage. Your lender should submit Form 1099-C to the IRS and send you a copy, showing the amount of the forgiven debt.
Exceptions to the Rule
Although you must report the canceled debt as income, you may be able to avoid paying taxes on it if you were insolvent at the time of the short sale -- the total value of the property and assets you owned at the time was less than the debts you owed. Filing for bankruptcy is another option.
The Mortgage Forgiveness Debt Relief Act
The Mortgage Forgiveness Debt Relief Act provided many homeowners with relief from this type of taxation through the end of 2013. Congress voted to extend the act through the end of 2014 so if you sold your property through the end of that year, you shouldn’t have to pay taxes on the deficiency. Check with an accountant to learn the status of the law in future tax years, because it’s possible Congress might extend the act again.
- Andy Dean/iStock/Getty Images