Short Sale Tax Implication
Short-sale is selling short of the mortgage balance. If the bank agrees that this is a better option rather than heading to the full foreclosure, a short-sale will happen.
Taxable Income
Closing a short-sale deal is not an easy process because seller normally carries second loan in additional to the mortgage, and both lenders are required to approve the transaction. When disagreement among the lenders do not get resolved, the deal is off. This process can be time-consuming.
Once it is finally closed. You are actually facing with a tax situation. No, I am not talking about the capital gain. Don’t know how it is impossible in a short-sale scenario. You may be surprised, but the portion of the loan that you end up not paying, or the “short” part, is considered your income.
When your pay less to your bank to settle the mortgage, the forgiven portion of the loan is treated as your taxable income. You should get a Form 1099-C from the lender at the end of the year, which reports the loan reduction amount to the IRS. IRS’s computer will make sure you report that as taxable income.
Tax Relief
Good news!! For the period of 2007 to 2012, you may be able to claim special tax relief and exclude the debt forgiveness income. Under the Mortgage Forgiveness Debt Relief Act of 2007, you may be able to exclude up to $2 million of debt forgiven on your principal residence.
Note that this is applicable only to mortgage related to purchase of principal residence, not the second home and not rental properties. If you qualify, you claim the special exclusion by filling out Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, and attaching it to your federal income tax return for the year.
Are You in Good Hands?
I happen to have a few acquaintances who have properties to sell for normal reasons, but they were told by their real estate agents to jump on the bandwagon of short-sale. In spite of the tax relief, short-sale should be your last selling strategy to consider.
Just like foreclosure, it will definitely affect your creditworthiness or FICO score in negative way. If you have agents who suggest short-sale without proper justification, sorry, you are not in good hands. They are mostly likely taking a short-sighted approach just for the deal without caring for their clients’ financial well-beings.
More from Ask Matt CPA
- Gift Tax Exclusion
- Slow Down, Tax Ahead!
- Beyond the Annual Gift Tax Exclusion
- Island in the Sky
- Funny Thing About Home Buyers – Tips for Sellers
Ask Matt CPA Recommends
- Precious Stones (BaublesRus)
[...] to take action to collect that amount. Also, probably sometime later, the bank sends out a 1099-C, informing the I.R.S. that a certain amount of debt had been [...]