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. Legislation that went on the books at the start of 2007 significantly benefited some upside downers and did absolutely nothing for others. Those provisions only applied to debt forgiven through 2017, but Congress is working to extend it through 2019. While there was some lapse in this statute in 2018 and 2019, it has since been extended and is now available again through 2025.
What does that mean for you? Let's take a closer look at short sale taxes and tax forgiveness.
- The Mortgage Forgiveness Debt Relief Act of 2007 made it so mortgage forgiveness wasn't taxable as long as the mortgage covers a principal residence, and the debt was incurred to buy, build, or substantially improve the home.
- The situations in which a mortgage can qualify for tax-free forgiveness include loan modifications, foreclosures, short sales, and deeds in lieu of foreclosures.
- State tax issues may also apply, such as in California, where canceled debt for a short sale is not typically subject to taxation.
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.
If you're behind on your mortgage and unsure of what to do, consider contacting a HUD-approved housing counselor to review your options.
Who Benefited From The Mortgage Forgiveness Debt Relief Act of 2007?
The Mortgage Forgiveness Debt Relief Act of 2007 doesn't usually apply to home equity loans or cash-out mortgage refinancings 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:
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.
Short Sale Tax Implications Today
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.
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 compared to other states. With the extension of the provisions of the Mortgage Forgiveness Tax Relief Act through 2025, canceled debts on a short sale will most likely not be considered taxable income.
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.