Many short sellers are surprised to learn that, even though they’ve suffered a loss on the sale of their home, they might still owe the Internal Revenue Service come tax time. While it seems like adding insult to injury, if the difference between what you owed on the property and its fair market was forgiven by your lender, it might be taxable.
To avoid the long and unpleasant process of a foreclosure, some lenders agree to a short sale. In a short sale, the proceeds from the sale of property fall short of what is owed, and the lender agrees to accept less in exchange for releasing its lien. In this situation, the lender is required to report debt forgiveness on IRS form 1099-C. When a lender issues a 1099-C, it means the debt has been forgiven, but it also means that the amount of the deficiency could be considered taxable income.
Debt Not Forgiven
On the other hand, a lender could agree to the terms of a short sale without forgiving the debt. In this case, you would not be subject to income tax, but the lender would reserve the right to sue you at a later date for the deficiency. Even when a lender agrees to release its lien to create a clear title for the sale of the property, it doesn’t necessarily mean it’s forgiving the debt. If you do not receive a 1099-C, it means the lender could still come after you for the deficiency.
To complicate matters further, where you live can determine the consequences you’ll face for having completed a short sale. A loan is either recourse or non-recourse. If the property is located in a recourse state the lender can either forgive the debt or come after you for the deficiency. If the loan was taken out in a non-recourse state, the deficiency is not considered taxable income nor can you be sued for the deficiency judgment. The only reason a homeowner who has engaged in a short sale should receive a form 1099-C is if they live in a recourse state and the lender has forgiven the debt.
The IRS does allow income tax on forgiven debt to be exempt from tax for those who have suffered financial hardship. The tax code contains what is known as an insolvency clause. In short, if the total of your debts exceed the total of your assets, you are insolvent for tax purposes. Not to be confused with bankruptcy, insolvency can still be a bit complicated. Most people considering this route will consult with an accountant who has tax expertise.