In a short sale, are we responsible for the amount of debt that has been forgiven?

My mortgage lender has already reported to the credit bureaus a charge-off bad debt even though they have agreed to a short sale.  Do we owe taxes on the amount of debt that has been forgiven?

Asked on July 23, 2010 under Real Estate Law, California

Answers:

M.D., Member, California and New York Bar / FreeAdvice Contributing Attorney

Answered 10 years ago | Contributor

In the past a short sale would have generated taxable income based on the amount the sale proceeds were short of what was owed (ie the deficiency).  The IRS treated forgiven debt as taxable income, subject to regular income tax.  The good news is that there are some exceptions for the next 2 years.

Pursuant to "The Mortgage Debt Relief Act of 2007", taxpayers are generally allowed to exclude income from the discharge of debt on their principal residence. Under the Act debt that is reduced through a mortgage restructuring or mortgage debt that is  forgiven in connection with a foreclosure, will qualify for this relief.  The Act applies to debt forgiven through years 2007-2012. Eligible for this exclusion is forgiven debt up to $2 million ($1 million if married filing separately).  However, the exclusion doesn't apply if the discharge is for services performed for the lender or any other reason not directly related to a decline in the home’s value or the taxpayer’s financial condition.  Here is a link to the IRS site that will give this information to you in further detail:  http://www.irs.gov/individuals/article/0,,id=179414,00.html

At this point, you should consult directly with an attorney in your area for further advice.

SJZ, Member, New York Bar / FreeAdvice Contributing Attorney

Answered 10 years ago | Contributor

If the lender has in fact written off part of the debt (e.g. charged it off) and will not try to collect it from you, that is debt foregiveness--at least of that portion of the debt which has been foregiven. Debt foregiveness, the courts and IRS have consistely held, is income; i.e. not having to pay $100 is the same as earning $100. Therefore, you would have to pay taxes on the foregiven debt, at your usual tax bracket. This is a common--though not as widely known as it ought to be--negative consequence of being able to get a short sale approved by a lender. If the lender could still sue you for the balance, then it's not taxable income--though in that case, you'd be faced with a lawsuit and having to make good the deficiency. You've still come out ahead as is, with a short sale, just as much so as you had hoped or thought.


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