In many cases, people choose to sell their home in a short sale procedure because they can no longer afford to keep their homes. Banks consider short sale an alternative to foreclosure and while the borrower might find the short sale option better than a foreclosure, he still must carefully consider the tax implications.

Let’s assume you owe $100,000 on your mortgage and you are no more able to make your mortgage installments. Because of the condition of the economy you might just have the capacity to offer your home for $80,000, leaving the bank $20,000 short. The bank consents to close your document after you pay the $80,000 – all things considered, since 80% is better than nothing.

The problem is that the other 20% is not a gift or free ride. The government sees that other 20% as “income” even though you have never had the money in hand. When you prepare your income tax return you have the $ 20,000 of short sales as income for that year to record and will be required to pay additional income tax on it.

Keep the extra taxes you owe in mind as you complete your short sale process. You need to start putting some extra money away to be prepared when tax season rolls around again. A person would only pay tax if the home was an investment property in most cases due to the Mortgage Debt Relief Act. When this law was enacted, it benefitted those short selling their principal residence.

The 2007 Mortgage Debt Relief Act

In the past, homeowners applying short sales or deeds in lieu needed to pay the amount of the forgiven debt load. However, the Mortgage Forgiveness Debt Relief Act of 2007 (HR 3648) changed this for certain loans.

The new law provides for tax relief if your deficiency stems from the sale of your principal residence (the home that you live). Here are the rules:

  1. Loans for your primary residence: If the loan was secured for your principal residence and was used to buy or improve the house, you can exclude generally up to $ 2 million of forgiven debt. This means you do not have to pay the deficit.
  2. Loans on other properties: If you default on a mortgage that is secured by property that is not your primary residence (e.g. a loan on your vacation home), you will owe tax on the deficit.
  3. Loans secured by yet not used to enhance main living place: If you take out a credit, secured by your main residence, however utilize it to take a vacation or send your tyke to school, you will owe charge on any deficit.

How to deal with the 1099-c

When a homeowner decides to sell their home, but the house is worth less than they owe on their mortgage (for their Lender), the Lender takes a loss and the homeowner makes $0 on the sale of their home. The loss is negotiated with the lender by your broker.

During the year the short sale occurs the Bank shows a loss in their accounting. Therefore in order for them to indicate a loss, someone has a profit. That person is the homeowner (Seller). The owner is issued a 1099-c, this shows income.

Although the Seller did not get any income, this 1099c, is the phantom income.

The next question is how to deal with the 1099-c.

If the home was your primary residence, The Mortgage Forgiveness Debt relief Act of 2007- INTERNAL REVENUE SERVICE Publication 4681, applies to you. You must have lived in the home for 2 out of the last 5 years, it must be your primary residence and it cancels any debt around $2, 000, 000. This means you’ll not have to pay income tax on the 1099-C, the income will then be canceled or void.

If the house was an investment property, there is a way to avoid the taxes too. The first step is to check with your accountant, then see if you can make technical insolvency claim. In a nutshell, it means that your debts outweigh your assets, in the current real estate market, this is simple. You should claim technical insolvency at the time of the short sale and the 1099-c gets to be void.

The bankruptcy exemption to tax liability: If you don’t get an exception under the Mortgage Forgiveness Debt Relief Act, you may still be eligible for tax relief. If you are able to show you were legally insolvent at the time of the short sale, you won’t be subject to paying tax on the shortage.

Legal insolvency happens when your total debts are greater than the value of your entire assets (your assets are the worth in your real estate and personal property). To use the insolvency exclusion, you’ll have to prove to the satisfaction of the IRS that your debts went beyond the value of your assets.

In short, a large part of whether tax liability of a short sale is dependent on whether the house was a primary residence or not. In most cases, you will pay taxes on a short sale if it was your primary residence. However, all sellers considering the short sale need to consult their tax advisors for more information on whether or not they will be subject to tax liabilities after the sale.