For those struggling to make their mortgage repayments, a short sale might sound like the best option for you. However, a short sale can have taxable implications, and it’s essential to be aware of them when deciding if a short sale is the right option for you. Below, we’re uncovering the tax consequences of a short sale and determining if you can truly escape tax liability with this option.
What is a short sale?
A short sale is when a home sells for less than what the seller owes. The original lender must agree to the sale first as they won’t be getting all of their money back, in most cases. Short sales usually only happen when a house owner is facing foreclosure, and they must show some level of hardship for the lender to approve. In addition to this, the lender will typically agree to waive the debt on the caveat that they get all the proceeds from the short sale.
Short sale vs. foreclosure
Foreclosure is when your original lender repossesses your home because you fail to make your mortgage payments over an extended period of time. This will generally occur over multiple months of missed mortgage payments. After this, the lender will start pre-foreclosure, which is the first step of the foreclosure process. Unlike a short sale, foreclosure is involuntary, and the homeowner must proceed to engage in legal action initiated by the lender. While you can argue the foreclosure, the process is grueling —and you would need to have a solid case to defend at a trial.
Short sales and foreclosures are both options for homeowners behind on their mortgage payments. However, none end in financial gain for the homeowner, and you can be tax liable for either option.
What are the tax consequences of a short sale?
In theory, a short sale appears to be a good outcome, as it means that you can sell your home while still preparing for your move, and the lender will receive a portion of their money back. However, canceled debt is considered to be taxable income if the lender holds you liable for the total loan amount. The same rules also apply to foreclosure.
With this in mind, here are some of the tax implications following a short sale, beginning with income and federal tax:
- Federal and income tax. When the lender agrees to the short sale, they will report the forgiven debt. Your lender will give you a Form 1099 C, showing the amount of canceled debt. You will need to report this as a capital loss on IRS Form Schedule D for the tax year. Additionally, the IRS will view the amount as taxable, and you must report it on both federal and state taxes at year’s end if your state has an income tax.
- Capital gains tax. Even if your house is short sold for less than the value of your mortgage, you may still be liable for Capital Gains Tax if the selling price is greater than the adjusted basis value. An adjusted basis dictates the current value of your home and can increase if you have added more value to your property. It can also decrease if the structure is damaged, as in the case of a natural disaster.
Due to the nature of short sales, you’ll rarely have to pay Capital Gains Tax. If you do, you can exclude up to $250,000 of Capital Gains Tax on your taxes if you are filing as an individual and $500,000 for couples filing jointly. If you exclude any canceled debts from federal taxes, however, you must include a Form 982 for that tax year in your filing. This is for most cases. We always recommend contacting a legal or tax professional to address your specific situation.
Tax liability exemptions
There are a few circumstances in which you may be exempt from paying income tax on a short sale:
- You face bankruptcy: Any debts canceled after an individual declares bankruptcy are not considered to be taxable income, in most cases.
- You have a non-recourse loan: A non-recourse loan is when the lender’s only option is to foreclose the home after a default. In this case, any canceled debts are not taxable income, and the lender cannot take any legal action against you following foreclosure.
- You are insolvent: Insolvency is when you are unable to pay debts. In this instance, some or all of your canceled debt may not be considered taxable income, depending on the situation. Identifying whether you are truly insolvent is a complex process that requires the help of a tax professional.
- Certain farm debts: Farmers may be exempt from paying income tax on certain canceled debts, but the rules for this are complex, variable, and depend entirely on the nature of the situation.
If you’re navigating the short sale process, Ascent Law is here to assist you in proceeding with confidence. For more information and to book your free intro call, please contact us at (801) 432-8682. Our team looks forward to assisting you.