Taxes are a routine part of any home sale. The amount you pay depends on your capital gains on the property – the difference between your sale price and your cost basis. But what taxes do you pay when you sell your house for less than you owe?
It might seem counterintuitive, but even short sales come with a tax liability. Every short sale is unique, however, and you may be eligible for certain exemptions.
In this article we’ll discuss how short sales can affect your taxes and some exclusions to be aware of. We are not tax experts, and this information shouldn’t be used as tax advice. If you’re wondering about the tax implications of a short sale, consult an accountant or tax professional about your situation.
What is a Short Sale?
If you’re behind on your mortgage payments and need to sell, you might not have enough equity in your home to cover the full balance on your mortgage. This can happen if the real estate market has declined since you purchased your home, or if you borrowed too much against your home value over the years.
In order to sell a home with this negative equity situation, you need to ask your lender to approve a short sale. Ideally, the lender forgives the “shorted” payoff amount, allowing you to walk away with minimal damage to your credit score.
Other times, the lender may pursue a deficiency judgment where they force you to pay back the outstanding mortgage balance through a personal loan. Not all states allow this, but it’s still critical to hire an experienced short sale negotiator or attorney to represent your best interests and help you walk away with zero mortgage debt.
In general, lenders are willing to work with you on your short sale. If you’re struggling financially, a short sale is one of the best solutions for avoiding foreclosure.
How Does a Short Sale Affect Your Taxes?
A successful short sale ends with your lender forgiving the outstanding balance on your mortgage. You sell your house for less than you owe, and your lender takes a loss on the principal.
This forgiven debt – like other types of forgiven debt – is considered taxable income by the IRS.
After the sale, the bank will mail you Form 1099-C, “Cancellation of Debt,” and you’re responsible for claiming it as income on your tax returns.
Before you ask, “Do I really need to claim Form 1099-C on my tax return?” – yes, you really do. Your bank sends a copy to the IRS and if you don’t claim it, it’ll be flagged.
However, whether or not you have to pay any taxes on the canceled debt is another matter altogether.
Exceptions to Form 1099-C, “Cancellation of Debt” After a Short Sale
The amount of canceled debt after your short sale may or may not be taxable. A couple common exceptions to Form 1099-C include:
- If you filed for bankruptcy or were insolvent when the debt was forgiven
- If you qualify for the Mortgage Debt Relief Act’s QPRI exclusion
The Mortgage Debt Relief Act began in 2007 and excludes certain forgiven debt from being taxed as additional income.
The law has been extended periodically over the years. The latest extension goes through 2025 and applies to taxpayers who qualify for QPRI – Qualified Principal Residence Indebtedness.
Essentially, the property you short sell must have been your primary residence. Caps and other rules apply here, however, so it’s important to talk to a tax professional to see if you qualify.
Example of Taxes Owed After a Short Sale
When you sell your home in a short sale, you can do a quick calculation of what taxes you might be liable for. Here’s an example:
- Enter the total amount of the debt immediately prior to your short sale: $330,000
- Enter the sale price of the property: $290,000
- Subtract #2 from #1 ($330,000 – $290,000). $40,000
In this example, $40,000 is the amount that you should see on box 2 of Form 1099-C. This amount is considered income and may be taxable unless you meet one of the exceptions mentioned above. If it is taxable for you, you would enter it on the line for “Other Income” on your tax return.
How an Experienced Short Sale Team Can Help
All short sales carry some financial consequences, be it credit score damage, reduced buying power, and even taxes.
The degree of damage, however, depends greatly on the skill and experience of the short sale team you hire. Your short sale listing agent and short sale negotiator or attorney will represent your best interests and help you limit whatever damage occurs from your short sale.
Their fees will also be paid for by your lender, leaving you more flexibility to hire a tax accountant to help sort out your taxes after the short sale. It’s important not to skimp on experience here, as you may be surprised to find you qualify for a lot more tax relief than you previously assumed.
Tax laws are lengthy and complicated, and exceptions are out there for every circumstance imaginable. Speak to a tax professional when you start your short sale process and get advice specific to your situation.
If you live in the Washington, DC metro area, call Marc Dosik and the Fed City Team to discuss your options for a short sale. Marc and his team have rescued over 130 homeowners from foreclosure proceedings. They help you sell your home and work with your lender to get the mortgage deficiency forgiven, all at no cost to you. They even negotiate with the lender to pay your relocation costs, giving you $3,000 or more cash-in-pocket to help you get back on your feet.
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Disclaimer: Every homeowner’s situation is unique, and local, state and federal laws change regularly. As such, this information should not be considered as legal, tax, financial or investment advice. Consult a qualified professional before making any financial decisions.