A short sale is an alternative to foreclosure. In a short sale, you work with your lender and sell your home for whatever price you can get. If the sales price is less than your mortgage balance, the lender agrees to forgive the difference. The Internal Revenue Service (IRS) might see that difference as income, which means there could be short sale tax implications. In the past, a key change in the tax code helped home sellers who owed more on their mortgages than their homes were worth. These sellers had negative equity a condition also known as being upside down or underwater.
The Mortgage Forgiveness Debt Relief Act of 2007
Here’s how the Mortgage Forgiveness Debt Relief Act of 2007 helped homeowners. Suppose Sela Sellers sold her residence in a lender-approved short sale that erased the unpaid part of her mortgage. Generally, the tax code calls for Sela to report partially or entirely forgiven amounts on her 1040 form. The Mortgage Forgiveness Debt Relief Act of 2007 changed that. It included a provision that allowed home sellers like Sela to exclude as much as $2,000,000 of canceled debt.
Sela could exclude these taxes if she satisfied two stipulations:
• The security for her mortgage was her principal residence, meaning the place she ordinarily lives most of the year.
• She incurred the debt to buy, build, or substantially improve her principal residence.
The Mortgage Forgiveness Debt Relief Act of 2007 doesn’t usually apply to home equity loans or cash-out mortgage refinancing unless these products were used to make improvements to the home. The Relief Act also doesn’t apply to debts on vacation homes and other second homes or rental properties. The Mortgage Forgiveness Debt Relief Act of 2007 benefited people whose debts were reduced or canceled in arrangements that are known as:
• Loan modifications
• Deeds in lieu of foreclosure
• Short sales
In tax lingo, the Mortgage Debt Relief Act of 2007 applied to income from the discharge of qualified principal residence indebtedness (QPRI). This means mortgages taken out by owners to buy, build, or substantially improve their principal residences. There was also a provision for debt reduced through mortgage restructuring, as well as for debt used to refinance QPRI. The relief was only up to the amount of the old mortgage principal, just before the refinancing. The Relief Act did not help homeowners who took advantage of the run-up in real estate prices to do “cash-out” refinancing but didn’t use the funds for renovations of their primary residences. Unless Congress approves the Mortgage Forgiveness Tax Relief Act of 2019, proceeds on a short sale could be considered taxable income. Long-standing rules generally require debtors to report all forgiven debts on their 1040 forms, just the same as income from salaries or investments. The IRS taxes forgiven debt at the same rate as ordinary income from sources like salaries. Some forgiven debts sidestep taxes, such as forgiven debts from bankruptcies and insolvencies. Be aware that canceled debt is not just a federal tax issue. You may need to check with your state to find out the state taxation possibilities that apply to your situation. As with most tax situations, the best approach is to work with an experienced tax professional.
When the Lender Pursues a Deficiency
In a short sale, the sale price is “short” of the amount you owe to the mortgage lender. The difference between the total debt owed and the sale price is the “deficiency.” In many cases, the lender can seek a personal judgment against you after the short sale to recover the deficiency amount. Generally, once a lender gets a deficiency judgment, it may collect this amount. On the other hand, the lender might choose to forgo pursuing a deficiency judgment, forgive the deficiency amount, and issue you a 1099-C (“Cancellation of Debt”) form instead.
“Cancellation of Debt” as Taxable Income
If a short sale results in a deficiency, but the lender decides not to come after you for payment and forgives the debt, this means you’re no longer under an obligation to repay the lender. The lender is then usually required to report the amount of the canceled debt to you and the IRS on a Form 1099-C. If this occurs, you might have to include the forgiven amount as income for federal tax purposes. (That additional income might also affect your state taxes.)
Other Ways to Escape Tax Liability for a Deficiency
The IRS provides a few exceptions and exclusions to the general rule that canceled debt is included in the gross income of the taxpayer. They include:
• debt discharged in bankruptcy
• some farm debts, and
• Non-recourse loans.
Getting Tax Assistance
Tax laws are complicated. If you received a 1099-C form indicating your lender forgave all or part of your mortgage debt, or if you’re considering completing a short sale or deed in lieu of foreclosure that has tax implications, talk to a tax attorney or tax accountant to get advice specific to your circumstances.
Qualified Principal Residence Indebtedness (QPRI) Exclusion
You might be able to exclude all or a portion of the forgiven amount from your income under the Qualified Principal Residence Indebtedness (QPRI) exclusion, if all of the following requirements are met:
• The forgiven debt was used to buy, build, or substantially improve your principal residence or to refinance debt incurred for those purposes.
• The debt was forgiven in years 2007 through 2020, or discharged after 2020, pursuant to a written agreement entered into before January 1, 2021.
Up to $2 million of forgiven debt qualifies for the exclusion. But 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 doesn’t qualify.
Debt Excluded from Federal Taxable Income
There are several instances when the IRS does not require canceled debt to be treated as income:
• Debts discharged in bankruptcy are not treated as taxable income.
• 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.
• 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.
• Nonrecourse debt which is forgiven is not treated as taxable income. (Nonrecourse debt is a loan where the borrower is not personally liable for repayment.)
Getting Tax Assistance
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. Also, tax laws are complicated. If you received a 1099-C form indicating your lender forgave all or part of your mortgage debt, or if you’re considering completing a short sale or deed in lieu of foreclosure that has tax implications, talk to a tax attorney or tax accountant to get advice specific to your circumstances.
Options if You Don’t Qualify
If you fall into one of these exceptions or if the IRS finds another reason their “generally” clause blocks you out, you can still find relief in other parts of the tax code.
• Bankruptcy: If your home and mortgage are included and discharged through bankruptcy, the forgiven debt is generally not taxable.
• Nonrecourse Loans: In several states, home loans are “nonrecourse,” which means your lender’s remedy for default is limited to the value of the property secured by your loan. The lender may not pursue your other assets to satisfy the debt. Forgiveness of a nonrecourse loan doesn’t represent taxable income to the borrower. Mortgages are nonrecourse in 12 states (Alaska, Arizona, California, Connecticut, Idaho, Minnesota, North Carolina, North Dakota, Oregon, Texas, Utah, and Washington state). But check with your attorney to see if there are any other provisions in your community.
• Insolvency: If your total liabilities exceed your total assets, then you’re technically “insolvent,” and forgiven debt may qualify under the insolvency exclusion. If you’re insolvent, the IRS doesn’t usually require you to include forgiven debts in your income. If you think you fall into this category, talk with your tax attorney. The substantiation requirements for this exclusion are considerable, and you need a pro to help you prepare the paperwork.
Both short sales and foreclosures are usually the result of a borrower’s inability to continue making mortgage payments. A short sale is where your mortgage lender allows you to sell the home for less than your outstanding loan balance and cancels your obligation to repay the remainder of the loan. With a foreclosure, the mortgage lender will take possession of the home if it doesn’t receive scheduled mortgage payments over an extended period of time. Also, in many cases, the lender cancels your outstanding mortgage balance. Sometimes, this debt cancellation is taxable as ordinary income. When your foreclosure includes a cancellation of debt, you only have an obligation to report it as ordinary income if you were personally liable for the entire mortgage, despite the security interest your lender takes in the home. This amount will be reported in Box 2 of a 1099-C that the lender will send you. You also need to calculate the capital gain that results from the foreclosure. To calculate the gain, subtract your tax basis in the home generally the purchase price plus the cost of home improvements you make from the home’s fair market value. However, if you’re not personally liable for debt that remains, use the outstanding mortgage balance at the time of foreclosure instead of the home’s fair market value.
Gain On Short Sales
Similar to a foreclosure, any debt that your mortgage lender cancels because of a short sale is taxable only if the terms of your mortgage hold you personally liable for the full amount of the loan. Regardless of the tax consequences, your lender will report the debt cancellation on a 1099-C form.
For example, if you owe $500,000 to your mortgage lender and short sale the home for $450,000, your lender will report $50,000 of canceled debt on your 1099-C. Since most mortgage lenders wouldn’t agree to a short sale if the value of the home exceeds the outstanding mortgage balance, usually no capital gains issues exist.
Through the end of 2019 you may have been eligible to exclude canceled debt from your tax return if it related to qualified principal residence indebtedness and met the requirements of the Mortgage Forgiveness Debt Relief Act. This could have also been applicable to debt that was discharged in 2020 provided that there was a written agreement entered into in 2019. Mortgages include those you obtained to buy, build or substantially improve a home and for which the lender retains an interest in the home until it’s paid off. You may be able to exclude the capital gains as well. If you lived in the home and were the owner for a total of two years during the most recent five-year period, you can exclude up to $250,000 of the capital gains or up to $500,000, if filing jointly, in some cases.
The Foreclosure Process in Standard Situations
When a person cannot pay the loan, interest, certain payments or is unable to provide the necessary money for a duration of time, he or she will face foreclosure when there are no arrangements with the lender. The debt requires repayment and the foreclosure is the process to provide the bank or other type of lender with the funds to account for the missing money. This generally follows certain steps starting with paperwork with the lender and then proceeding to the next stage. The holder of the mortgage will provide notice of the default payments through written documentation. This will also provide the formal notice of default payment.