Short sales are occurring with increasing frequency as a result of the poor economy and shrinking home values. What many people don’t realize is that if your lender allows you to sell your home at a loss, you may be liable for taxes on the losses incurred by the lender. The IRS considers a short sale loan forgiveness. Loan forgiveness is considered debt discharge income (DDI), and DDI is taxable.
If a lender forgives more than $600 of principal, they might send you and the IRS a 1099-c form, and you are required to report the loss as income. In many cases whether you have a tax liability or not will depend upon your lender. Some lenders will report the DDI to the IRS, others will not.
In addition to DDI, there can be other tax implications to a short sale. Take for example the case of someone who bought a $100,000 home. The market did well and the property increased in value to $125,000. At the peak the borrower taps the home’s equity and took out a second mortgage for $50,000. Now the borrower has a house worth $125,000 and $150,000 worth of mortgages (first and second). The market stagnates and they sell the house in a short sale for $125,000. For tax purposes, they have actually made $25,000, despite being $25,000 shy of breaking even on their mortgages. This is because the sales price exceeds the tax basis of the home. Mortgage debts do not factor into gain-on-sale calculations. This is in addition to the taxes that must be paid on $25,000 worth of DDI. It is possible that the $25,000 gain may be excluded from taxes as a result of the federal home sale gain exclusion tax break.
Now take the example of a person who purchased a home (to be their primary residence) for $100,000, the market improves and the house appreciates to $125,000. The homeowner borrows $50,000 against their home equity, and now has $150,000 worth of mortgage debt. Then the market declines and the house is worth $75,000 and is sold in a short sale. The borrower is left with $50,000 worth of DDI, but they have also incurred a $25,000 loss on the property. The borrower may not deduct the loss. This is because you may only claim losses on investment or business properties, not principal residences.
There are some circumstances where DDI can be exempt from taxes. If the debt write-off is deemed a gift, discharged in bankruptcy, or you were insolvent (have debts that are in excess of your assets) at the time the lender forgave your debt, your DDI may be exempt from taxes.
