Short Sale Tax Implications: What Sellers Need to Know

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All this week, we’ve been discussing short sales – from the seller’s perspective – here on In this last post of the series, we’re going to look at the tax implications of doing a short sale.

If You Do a Short Sale, You Could Owe the IRS Money 

Many homeowners don’t realize this, but when you do a short sale, the government counts the “shortfall” as income – income that you have to pay taxes on.

If you’re shaking your head going, “I still don’t understand,” it’s explained excellently in the real estate article, Lost your home, You may owe IRS:

In many cases, the tax problem associated with a foreclosure arises from a seemingly benevolent move: The lender forgives some of the loan. This happens when a lender and a borrower negotiate a reduction in loan amount. Or when the lender forecloses on the property and sells it for less than the outstanding mortgage [ie, does a short sale].  . . .

In both instances, the difference for which the borrower is no longer responsible is considered cancellation-of-debt, or COD, income. [As taxable income] the tax on COD is calculated at ordinary rates, which range from 10% to 35% and depend upon your income. 

Who Is More Likely to Owe Taxes When Doing a Short Sale

In 2007, Congress passed the Mortgage Forgiveness Debt Act (discussed below), but that doesn’t let everyone off the hook. Following are the exceptions to the rule (Source:, Les Christie (04/08/2010):

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**Anyone who did a cash-out refinance and spent the money on something not housing related, then got in trouble and lost their home to a foreclosure or short sale, will owe the IRS as if the money from the refinance were earned income.

**The IRS will forgive tax liability only on money from home-equity loans that was spent to improve the property. 

**Anyone who lost a vacation home or investment property to foreclosure or short sale will owe Uncle Sam.

**Multi-million dollar homes — lost or sold — are always subject to tax. 

The good news is, if the above doesn’t apply to you, any IRS obligation you owe will probably be forgiven.

Why It’s Critical from a Tax Standpoint to Complete Your Short Sale Before 12/31/2012

Why is this? We explained it in post we did earlier this year about options for homeowners who are facing foreclosure, writing:

Home Foreclosure and Taxes: Important Tax Consequences of a Short Sale after December 31, 2012

For example, if you owe $200,000 on your home and you sell it for $100,000, the government will tax you on the $100,000 difference because it’s seen as a financial “windfall.” So if you’re going to do a short sale, be sure to do it BEFORE December 31, 2012. Remember, in this market, it’s taking homes months and months — some more than a year — to sell. So if this is an option you’re considering, don’t delay too long. FYI, the tax break applies only to primary residences.

Short Sales: Recourse vs No Recourse — What Is This & Why Is It Important for Sellers to Know?

An important consideration in the results of a foreclosure (or a deed in lieu of foreclosure) is whether the debt is “recourse” or “nonrecourse.” If the debt is “recourse,” the debtor is personally liable for the debt. If the debt is “nonrecourse,” the debt is only secured by the property, and the debtor is not personally liable for the balance. –Source: Tax Consequences of a “Short Sale” of Real Estate vs. Foreclosure

This is critical to understand, because short sales are taxed under the same rules as foreclosures. 

How to Ensure That You Don’t Owe Any Taxes If You Do a Short Sale

Many foreclosure / real estate attorneys advise clients to file for bankruptcy. And potential tax obligations is one reason why.

Learn more about The Mortgage Forgiveness Relief Debt Act and Debt Cancellation Law — and the tax implications of a short sale. And, see Suze Orman’s explanation on Oprah about short sales and tax implications.

If you’re unsure about the short sales taxes and how it impacts what you might owe, consult a foreclosure attorney and/or a tax lawyer – in your jurisdiction. Knowledge in this case is definitely power.

Related Posts

The Short Sale Process: How to Find a Short Sale Buyer for Your “About to Be Foreclosed On” Home

What Is the Bank Short Sale Process for Sellers?

Short Sale: Definition, Credit Implications, Tax Implications & More

Stop Foreclosure: How to Ready Your Home for a Fast (Short) Sale

2 Foreclosure Options for Homeowners with Little or No Equity in Their Homes

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Copyright © 2011 Yuwanda Black for Foreclosure Business News. Article may not be reprinted or reproduced in any manner without the express, written consent of the author.

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