Do I Pay Taxes on a Short Sale? What About on a Forgiven Debt

Today's question is, do I pay taxes on a short sale?

As we've discussed in previous videos, a short sale is a real estate transaction where the net proceeds aren't sufficient to satisfy the underlying mortgage debt. Therefore, you have a shortfall amount or what we call a deficiency. 

In the event that the lender waives its right to collect a deficiency balance, 

for example forgives that debt, then that in and of itself constitutes a taxable event resulting in forgiven debt income. Which may result in a tax liability for the borrower. If everything was done properly during the negotiations, then yes, there will be a resulting forgiven debt amount. Now whether or not you have to pay tax on that forgiven debt amount is a different question. So, following the short sale transaction, assuming that the lender forgives that balance, that will result in cancellation of debt income and the lender will issue a 1099 C tax form reflecting that amount of forgiven debt income, which may or may not result in a tax liability for the borrower.

If Congress renews the Mortgage Forgiveness Debt Relief Act, 

then you will be shielded or exempt from any tax liability arising from that forgiven debt. If the property was a qualified principle residence or if the loan proceeds that are being forgiven were originally used as purchase money. 

If, however, Congress fails to renew the act,

then we still have a fallback known as the insolvency clause of the Internal Revenue Code. It's not a piece of legislation. It's a tax code or a tax regulation baked in to the IRC, the Internal Revenue Code. And so long as the borrower is insolvent by more than the amount of forgiven debt, then the borrower will not have to pay any taxes arising from that forgiven debt income or that cancellation of debt income.

As we've discussed in previous videos one's insolvency is a product of their debts and liabilities versus their assets. 

If their debts and liabilities exceed their assets, then they are insolvent. If your debts and liabilities exceed your assets by more than the amount of forgiven debt, then you won't have to pay any taxes on that cancellation of debt income. But remember, like we've discussed in previous videos, the insolvency clause is not an all or nothing game. You are shielded dollar for dollar up to your insolvency amount against any forgiven debt income. For example, let's say the bank forgives $100,000 of debt. In a separate equation and a separate calculation we determined that our insolvency is only $80,000. Well you're shielded dollar for dollar up to that first $80,000 of insolvency. So you're only paying tax on the remaining $20,000 of forgiven debt income based on your tax bracket.

So these are the key factors you'll have to take into consideration when determining whether or not you'll have to pay taxes on the short sale. Be sure to consult with a tax attorney so you get the most accurate information regarding potential tax liability.

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