How Canceled Debt on a Short Sale Might Result in a Tax Liability

Each Situation is Unique for Relief from Short Sale Taxation

Short Sale Tax Relief
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By Julian Block, Attorney

If you're looking for short sale tax relief, not every seller will be entitled to mortgage forgiveness after a short sale. However, a key change in the tax code helps millions of home sellers who owe more on their mortgages than their dwellings are worth. These sellers have negative equity — a condition known colloquially as being upside down or underwater. Legislation that went on the books at the start of 2007 significantly benefits some upside downers and does absolutely nothing for others.

The Mortgage Forgiveness Debt Relief Act

This is how the break works. Suppose Sela Sellers disposes of her residence in a lender-okayed short sale that erases the unpaid part of her mortgage. Or suppose the lending company forecloses on the dwelling, subsequently sells it and cancels a portion of her debt. Generally, the tax code calls for Sela to report partially or entirely forgiven amounts on her 1040 form. Not any more. The Mortgage Forgiveness Debt Relief Act of 2007 includes a provision that allows home sellers like Sela to exclude as much as $2,000,000 of canceled debt.

Sela excludes (sidesteps) taxes only if she satisfies two stipulations:

  • The security for her mortgage is her principal residence, meaning the place she ordinarily lives most of the year.
  • She incurs the debt to buy, build or substantially improve her principal residence.

Canceled Debt on a Short Sale

There is no relief for Sela’s home equity loans or cash-out mortgage refinancings, except to the extent that she uses the proceeds to make improvements. Other fine print prohibits relief if her lenders forgive debts on vacation homes and other second homes or rental properties.

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 Internal Revenue Service taxes forgiven amounts at the rates for ordinary income from sources like salaries. Some forgiven debts sidestep taxes. The law specifies several carefully hedged exceptions. They include bankruptcies and insolvencies.

Exclusions to Canceled Debt Taxation

The exception introduced in 2007 benefits people whose debts are reduced or canceled in arrangements that are known as:

  • Loan modifications
  • Foreclosures
  • Deeds in lieu of foreclosure
  • Short salesThis last category is the term for an owner who — with lender approval — sells for a net sales price (gross sales price minus legal fees, broker’s commission and other costs) that is insufficient to cover all of the outstanding debt.
    • In tax lingo, the exclusion is for income from the discharge of QPRI, short for qualified principal residence indebtedness. This means mortgages taken out by owners to buy, build, or substantially improve their principal residences. And the residences are the securities for the debts.
    • There also is an exclusion for debt reduced through mortgage restructuring, as well as for debt used to refinance QPRI. Here, there is relief, but only up to the amount of the old mortgage principal, just before the refinancing.
    • Another constraint is that the exclusion does not help home owners who took advantage of the run up in real estate prices to do “cash-out” refinancing, in which they did not use the funds for renovations of their primary residences. Instead, they used the funds to pay off credit card debts, tuition charges, medical expenses, or certain other expenditures.
    • Taxation on canceled debt for a short sale does not apply in the state of California, under most circumstances, due to California Code Civil Code 580e. The way to approach a California short sale is unique over the laws that govern short sales in other states. Part of the relief is due to the fact banks are not allowed to pursue sellers after closing for a deficiency.

​Further, please beware that canceled debt is not just a federal issue. You may need to check with your own state to find out the taxation possibilities that apply to your own situation. For example, the Franchise Tax Board issued a letter in California exempting most homeowners.

There is also no guarantee Congress will continue to extend the Mortgage Forgiveness Debt Relief Act, although there is a bill pending to extend it through 2018.

At the time of writing, Elizabeth Weintraub, CalBRE #00697006, is a Broker-Associate at Lyon Real Estate in Sacramento, California.

Edited by Elizabeth Weintraub, Home Buying Expert