Short Sale Sellers - What the banks don't want you to know

Short Sale Sellers beware of what the banks are telling you! I recently had a prominent bank with a 'stage coach' in the logo (got it now?) tell one of my sellers - no, I'll take that back - try and scare the hell out of my seller that she would have to pay taxes on the additional income from her pending short sale. Frozen in fear, she did nothing until I found this law recently enacted for just these situations.

Are the banks trying to scare you? You bet they are! Are they telling you about financial decisions that are beneficial to you? I doubt it! The purpose of this post is so that you can go into a short sale situation with your eyes wide open and know what the outcome will be for your credit and your tax situation.

Is Cancellation of Debt on a Short Sale always taxable? The good news is NO.

Here's why - it's called the Mortgage Forgiveness & Debt Relief Act enacted on 12/20/2007. Why haven't we known about this? I've just heard of it and I'm thrilled for some of my seller clients that are currently selling or thinking of selling on a short sale. As if their situations weren't bad enough, the short sale differences we were told by the lenders would be a tax liability. Now I find out that in most instances that is not the case!

The most common situations when cancellation of debt income is not taxable involve:

• Qualified principal residence indebtedness: This is the exception created by the Mortgage Debt Relief Act of 2007 and applies to most homeowners.
• Bankruptcy: Debts discharged through bankruptcy are not considered taxable income.
• Insolvency: If you are insolvent when the debt is cancelled, some or all of the cancelled debt may not be taxable to you. You are insolvent when your total debts are more than the fair market value of your total assets.
• Certain farm debts: If you incurred the debt directly in operation of a farm, more than half your income from the prior three years was from farming, and the loan was owed to a person or agency regularly engaged in lending, your cancelled debt is generally not considered taxable income.
• Non-recourse loans: A non-recourse loan is a loan for which the lender’s only remedy in case of default is to repossess the property being financed or used as collateral. That is, the lender cannot pursue you personally in case of default. Forgiveness of a non-recourse loan resulting from a foreclosure does not result in cancellation of debt income. However, it may result in other tax consequences.

So ..... Short sale sellers take the full loan balance and subtract the sales price. This is a positive number and is treated as 'ordinary income'.

Here are the conditions and requirements that the seller not be taxed on this income for federal income tax purposes (note, not necessarily state taxes) if the following conditions are met:

• You lived in the home - primary/principal residence
• The loan was used to buy, construct or improve that home referenced in #1
• The income not taxed is capped at $1 million for a married person filing separate and $2 million otherwise
• The short sale has to take place after Jan 1, 2007 and before January 1, 2013 (any guess as to how long the government thought this might be an issue?)

Questions I've snatched for further clarification: If I sold my home at a loss and the remaining loan is forgiven, does this constitute a cancellation of debt?

Yes. To the extent that a loan from a lender is not fully satisfied and a lender cancels the unsatisfied debt, you have cancellation of indebtedness income. If the amount forgiven or cancelled is $600 or more, the lender must generally issue Form 1099-C, Cancellation of Debt, showing the amount of debt cancelled. However, you may be able to exclude part or all of this income if the debt was qualified principal residence indebtedness, you were insolvent immediately before the discharge, or if the debt was canceled in a title 11 bankruptcy case. An exclusion is also available for the cancellation of certain nonbusiness debts of a qualified individual as a result of a disaster in a Midwestern disaster area. See IRS Form 982 for details.


More frequently asked questions here.
Publication 4681
Release IR-2008-17




Note and Disclaimer: This is a very complex situation and should be verified by your accountant or the IRS. I am in no way giving tax advice only passing along information that I have been made aware of recently. I am in no way an attorney or tax advisor so please verify all these statements in their entirety. It seems in California, this income is still taxable so please verify with your state of residence.


Resources: IRS, Dr. Danielle Babb, Landlord Protection Agency