Tax Consequences of a Short Sale of Your Principal Residence.

Here in our Chicago South Loop Tax Preparation office, we are meeting more taxpayers who are struggling to meet their financial obligations. Reasons for taxpayers’ lack of funds range from being laid off from work to increased property tax bills, in some cases with increases of up to 200%. Of course, with reduced incomes, some homeowners are unable to pay their mortgages on time, if at all. Read on to see the tax consequences of choosing the alternative option to foreclosure.

Many homeowners don’t want to go through the stress and embarrassment of a foreclosure, and most don’t want to damage their credit rating any further than necessary. While a short sale will still impact the homeowner’s credit rating, it will not have as significant an impact on the credit rating as a foreclosure would. Fortunately, there is an alternative for homeowners having trouble making their mortgage payments: a short sale.

Short sales avoid foreclosure, but they can result in tax liabilities. In a short sale, homeowners sell their home in a regular sale through a real estate agent for less than the amount of their mortgage. The lender accepts the sale proceeds, releases the mortgage lien on the property, and typically writes off the remainder of the loan as an uncollectible debt.

Lenders agree to short sales only where it’s clear that

• the home is worth less than what the homeowner owes, and
• the homeowner is financially unable to keep up the mortgage payments due to job loss, health issues, death, or other hardship circumstances.

Typically, a short sale involves forgiveness of part of the mortgage debt owed by the homeowner. Debt forgiveness can constitute taxable income to the borrower. Whether the debt forgiven in a short sale is taxable income depends on several factors, including whether

• the mortgage is a recourse or a non-recourse loan,
• the forgiven debt qualifies for the qualified principal residence indebtedness exclusion, or
• the homeowner was insolvent at the time of the debt cancellation.

Forgiveness of a non-recourse loan (a loan for which the borrower is not personally liable) does not result in taxable income to the borrower. Twelve states allow only non-recourse home loans, but recourse loans (click here to read about recourse loans) are standard practice in the other 38 states.

Fortunately, for underwater homeowners who have recourse loans, Congress passed the Mortgage Forgiveness Debt Relief Act in 2007. Thanks to this law, up to $750,000 of “qualified principal residence indebtedness” forgiven by a lender is excluded from tax. This exclusion remains in effect through 2025 and applies only to debt to acquire or build the taxpayer’s principal residence.

Example. Susan Taxpayer’s primary residence has a $750,000 recourse mortgage loan, for which she is personally liable. Since she purchased the home, its value has declined to between $600,000 and $650,000.

Susan lost her job and can’t find another job with a salary large enough to pay her mortgage. Presented with these facts, Susan’s lender agrees to allow a short sale of the property for $635,000 and cancels the remaining $115,000 of mortgage debt. The $115,000 is qualified principal residence indebtedness that Susan may exclude from income tax.

Homeowners who don’t qualify for the qualified principal residence indebtedness exclusion can still avoid paying tax on their canceled indebtedness if they were insolvent when the debt was canceled. Taxpayers are insolvent if their total liabilities exceed the fair market value of all their assets immediately before the cancellation of the debt. It’s likely that most homeowners who can get their lenders to agree to a short sale qualify as insolvent.

Example. Tina Taxpayer’s main home has a $3,000,000 recourse mortgage loan. The home has declined in value to between $2,000,000 and $2,250,000.

Tina’s lender agrees to a short sale for $2,150,000 and cancels the remaining $850,000 of mortgage debt. Tina does not qualify for the exclusion for qualified principal residence indebtedness because more than $750,000 of debt was discharged, but she may still exclude the $850,000 from her income if she was insolvent when her lender canceled the debt.

Although we’ve given you the basics, this is not an all-inclusive article. Should you have questions, or need business tax preparation, business entity creation, or business compliance assistance please contact us online, or call our office at 855-743-5765. Do you owe the IRS, or your state back taxes? Do you have unfiled tax returns? Is the IRS threatening to garnish your paycheck, or levy your bank account? Are you ready to get back on track with the IRS? Howard Tax Prep LLC will help you get back on track with the IRS, get into a settlement, or setup a payment with the IRS. Reach out to us now! Make sure tojoin our newsletter for more tips on reducing taxes, and increasing your wealth.

Author information: Trudy M. Howard is a managing member of Howard Tax Prep LLC, a Homewood IL, &  South Loop of Chicago tax preparation and accounting office.