Short Sale: Do Homeowners Owe Income Tax on the Amount of Mortgage Debt Forgiven?

Must a homeowner pay income tax on the amount of debt forgiven resulting from a short sale or "mortgage workout?"

One question I am asked frequently regarding short sales is this: “Must I pay taxes on the amount my lender writes off on my mortgage loan?”

A “short sale” is the sale of a property which nets the lender less than the outstanding principal amount and the lender agrees to accept less than what the lender is owed in order to eliminate the bad debt without going through the foreclosure process.  The question also applies to "mortgage workouts," in which a lender adjusts the mortgage amount downward to a more affordable level so the homeowner can make the payments and keep the home out of foreclosure. For example, a lender may recognize that a mortgagee has always been on time with their payments but has lost one job in what was once a two-income household, the values for the surrounding area of the home have dropped significantly, and the lender knows the only options other than a mortgage workout are 1) a short sale, which may net the lender 50 cents on the dollar, or 2) foreclosure, which may net them even less.  Keeping a mortgagee in a home, paying on 80% of their original mortgage amount is a smarter investment than either a short sale or foreclosure. It also builds loyalty with the homeowner, knowing the lender wants them to keep their home and is willing to work with them to do so.  It is good business.

In the past, when a lender forecloses on a property, sells the home for less than what is owed on it, or forgives any portion of the mortgage, it was perceived by the IRS as income and the homeowner was required to pay taxes on the shortfall unless they could prove insolvency or they declared bankruptcy. Even today, lenders are required to file a Form 1099-C (Cancellation of Debt) with the Internal Revenue Service and furnish a copy to the homeowner.

However, the enactment of Public Law 110-142, also known at the Mortgage Forgiveness Debt Relief Act of 2007 has changed the sellers’ tax liability when their home is sold through a short sale. The law went into effect on December 18, 2007, and has been extended by the Economic Stabilization Act of 2008 (Public Law 110-343) to exclude debt discharges from January, 2007 through December 31, 1012. In order to claim the exclusion, the homeowner must complete IRS form 982 and submit it with their federal income tax return.  The Mortgage Forgiveness Debt Relief Act of 2007 excludes from federal taxation lenders' discharges of debt up to $2 million, so long as it is a mortgage secured by the homeowner's principal residence and was incurred in the purchased, construction or substantial improvement of the principal residence.  A short sale which results in debt forgiveness on an income property would not be excluded from tax liability, for example.

Any homeowner who takes advantage of the exclusion must reduce their “basis” in the home – the “base cost” they paid for the home -- by the amount of the forgiven debt when determining their profit or loss upon resale. To illustrate, a homeowner who paid $150,000 for his home and had $50,000 of the mortgage debt forgiven, has an adjusted basis of $100,000.

The Mortgage Forgiveness Debt Relief Act of 2007 also extends the period of time in which a surviving spouse may claim the $500,000 universal exclusion which is otherwise only available to married couples, and it extends a homeowner’s option to itemize mortgage premium deductions.

For more information about the Mortgage Forgiveness Debt Relief Act and its tax consequences, consult your tax accountant or attorney.

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Lorena Williams
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Posted on Feb 2, 2011