Tax Implications in a Short Sale

The Mortgage Forgiveness Debt Relief Act of 2007 allows a homeowner to exclude from taxation income derived as a result of a loan modification, foreclosure, or short sale.  The purpose of this legislation is to alleviate the tax burden created by debt forgiveness for homeowners already struggling to stay afloat financially.  In October, 2008, California enacted similar mortgage debt forgiveness legislation covering debt forgiven in 2007 and 2008.  California is the only state to enact short sale tax laws.  

Allowable Tax Exclusions and Rules

The Mortgage Forgiveness Debt Relief Act applies to mortgage debt forgiven between January 1, 2007 and December 31, 2012 on primary residences only; key provisions include:

• Up to $2 million of qualifying debt may be excluded; the cap for married couples filing separately is $1 million;
• Canceled debt used to buy, build, or improve a principal residence or refinance debt used for those purposes qualifies for the exclusion; and
• Unpaid interest (that could have been deducted had it been paid) which was added to principal and subsequently forgiven is not taxable.

Canceled credit card debt, auto loan debt, and other types of canceled debts are taxable.  Additionally, the Mortgage Forgiveness Debt Relief Act does not apply to dividend taxes due on the short sale of stocks. 

How to Report Forgiven Debt on Your Tax Return

Any lender that has forgiven debt will send a Form 1099-C (Cancellation of Debt) to the taxpayer.  If the debt forgiven may be excluded from income, the taxpayer must complete the applicable sections of Form 982 and file it along with their tax return.

If the taxpayer does not receive a Form 1099-C, he must still report the forgiven debt to the IRS.  If taxpayer disagrees with the information on Form 1099-C, he should contact the lender immediately and ask that it issue a corrected 1099-C.

Getting Legal Help

If you are considering a short sale, you should speak with a qualified tax attorney or certified public accountant about federal short sale tax laws and how those laws will affect you.  If you have already completed a short sale, before filing your tax return, you should seek the advice of a tax attorney or a certified public account to ensure that you have completed the forms correctly.