Short Sale

In most cases, you must obtain permission from your lender ahead of time, before you can proceed with a short sale. Generally, in a short sale your lender agrees to let you sell your home for the current market value, rather than what you owe on your loan. For example, if you owe $350,000 on your mortgage, but your home is only worth $275,000, the lender agrees to let you sell the property for $275,000. The real key with a short sale is getting the lender to agree, in writing, to forgive the deficiency amount that remains after the sale. Be aware that the IRS may be looking to collect its portion of that amount.

Prior to 2007

Before 2007, the general rule regarding forgiven debts was that debtors had to report the total amount forgiven as part of their ordinary income to the IRS. The lender would usually be required to report the canceled debt on Form 1099-C, Cancellation of Debt, and the forgiven amount in a short sale would be taxed. The way the IRS looks at it, the debt you no longer have to repay is the equivalent of income you otherwise would not have.

Exceptions

The income may not be taxable if the debt was discharged as part of bankruptcy proceedings or if you can prove you were insolvent --- your total debts exceeded your total assets --- at the time the debt was cancelled. Therefore, you may not owe taxes for all or a portion of a short sale deficiency. The income is generally not taxable if the debt incurred was used for the operation of a farm and more than 50 percent of your income over the previous three years was from farming. The final exception involves a nonrecourse loan, for which the lender can repossess the property through a foreclosure but cannot pursue you personally for the default amount, which does not result in taxable income.

2007 and After

In December 2007, the Mortgage Forgiveness Debt Relief Act was enacted. It generally allows debtors to exclude any income from canceled debt if the debt was on their primary residences or was forgiven as a result of foreclosure or reduced with a mortgage restructuring. The new rule only applies to canceled debts in the calendar years 2007 to 2012. Up to $2 million of forgiven debt can be excluded, or $1 million if you are married filing separately. The exclusion does not apply if the debt was canceled for any other reason not directly related to the decline in your home's value or your financial situation.