A short sale occurs when a lender allows a homeowner to sell his house for less than the mortgage balance to avoid foreclosure. The lender can accept a loss and then release the homeowner from additional debt liability, or the lender can pursue a deficiency judgment to collect the amount owed. If the lender not pursue a deficiency judgment following a short sale, however, the former homeowner is still totally clear and free. The lending company will issue a Form 1099-C and the deficient amount may need to be included as income on the former homeowner’s tax return.
Canceled Debt
According to the IRS debts are taxable income. If a lender releases a homeowner out of her debt obligation, the homeowner has effectively gained income, which usually must be contained on her tax return. Suppose a homeowner owes $100,000 on her house and finds a buyer that will pay $80,000. The lender agrees to accept the purchase price and compose the remaining $20,000. The lender will send the former homeowner a Form 1099-C for the deficient amount of $20,000, which the IRS may consider taxable income.
Mortgage Forgiveness Debt Relief Act
The Mortgage Forgiveness Debt Relief Act allows homeowners to exclude canceled debt from income so long as the debt has been incurred to buy their primary residence, according to the IRS. This provision applies to debts discharged between 2007 and 2012 and is capped at $2 million ($1 million if married filing separately). Furthermore, this rule doesn’t apply for any motives besides a drop in home worth or a decline from the homeowner’s financial status.
Other Exceptions
Filing for bankruptcy may even absolve a taxpayer by paying a large tax bill because of forgiven debt. According to the IRS, debts discharged through bankruptcy can be deducted from taxable income. What’s more, demonstrating insolvency will even permit the citizen to exclude forgiven debt out of income. Insolvency occurs when a citizen’s total liabilities exceed total assets.