Tax Consequences of a Short Sale of Your Principal Residence
The real estate boom appears to be over for now.
Morgan Stanley predicts that house prices could fall by 10 percent by the end of 2024, or perhaps twice as much in a worst-case scenario.
Those who purchased their homes at the top of the market could be in trouble, especially if the U.S. falls into a recession.
It is true, homeowners donʼt want to go through a foreclosure and the resulting destruction of their credit rating. Fortunately, there is an alternative for homeowners having trouble making their mortgage payments: a short sale.
Short sales avoid foreclosure, but they can result in tax liabilities.
What Is a Short Sale?
A “short sale” is a way for ﬁnancially struggling homeowners to avoid foreclosure when their home is worth less than the amount of their loan. The lender allows the homeowner to sell the home in a regular sale through a real estate agent for less than the amount of the mortgage.
The lender accepts the sale proceeds, releases the mortgage lien on the property, and typically writes off the remainder of the loan as an uncollectible debt.
Why would a lender agree to do this? Because itʼs clear that:
- The home is worth less than what the homeowner owes, and
- The homeowner is ﬁnancially unable to keep up the mortgage payments due to job loss, health issues, death, or other hardship circumstances.
The homeowner must submit an application to the lender, including a hardship letter showing these circumstances. Lenders do not consider a decline in home value alone to be a hardship.
With a successful short sale, the lender collects as much as possible from the underwater property without having to go through the trouble and expense of foreclosure. The homeowner avoids bankruptcy or foreclosure.
A short sale will impact the homeownerʼs credit rating, but not as much as a foreclosure would. Both substantially reduce a homeownerʼs credit rating, but short sales usually remain on credit reports for a shorter period: about two to three years, compared with seven to ten years for foreclosures.
Potential Tax Liability in a Short Sale
Typically, a short sale involves forgiveness of part of the mortgage debt owed by the homeowner. Forgiveness of a debt can constitute income to the borrower. Such cancellation of debt (COD) income is taxed at ordinary income rates.
Key Point: The lender is usually required to report the amount of the canceled debt to the IRS on Form 1099-C, Cancellation of Debt.
Whether the debt forgiven in a short sale is taxable income depends on several factors, including whether
- The mortgage is a recourse loan or a non-recourse loan;
- The forgiven debt qualifies for the qualified principal residence indebtedness exclusion, or
- The homeowner was insolvent at the time of the debt cancellation.
Non-Recourse vs. Recourse Loans
There are two main types of loans: Recourse and Non-Recourse.
- With a recourse loan, the borrower is personally liable for the debt.
- With a non-recourse loan, the borrower is not personally liable. If the borrower defaults, the lender may go only
- After the property that was collateral for the loan and not collected against the borrower’s personal assets.
If the lender forgives a non-recourse loan following a short sale, there is ordinarily no taxable income to the borrower.
It works like this: You treat the non-recourse debt forgiven by the lender as the amount realized on the sale of the property. You then compare the amount realized to your basis to determine gain or loss. Technically, there’s no discharge of indebtedness income because you treat this as a sale.
Twelve states by law allow only non-recourse home loans: Alaska, Arizona, California, Connecticut, Idaho, Minnesota, North Carolina, North Dakota, Oregon, Texas, Utah, and Washington. In addition, all government-backed mortgages are non-recourse loans, even in the 38 states that allow recourse loans. These include VA, USDA, and FHA loans.
Recourse home loans are common in the 38 states that allow them. If the loan is a recourse loan, the forgiven debt will be taxable income unless one of the following two exceptions applies.
Exception 1. Qualiﬁed Principal Residence Indebtedness Exclusion
Fortunately for underwater homeowners who have recourse loans, Congress passed the Mortgage Forgiveness Debt Relief Act in 2007. Thanks to this law, many homeowners who have recourse mortgage debt forgiven before January 1, 2026, wonʼt owe any taxes on the forgiven debt.
The Mortgage Forgiveness Act discharges (forgives) up to $750,000 of “qualiﬁed principal residence indebtedness” and excludes that forgiveness from tax. (Before 2021, the amount was $2 million.) The exclusion is scheduled to continue through the end of 2025.
Here are the requirements a homeowner must satisfy for the exclusion:
- First, the mortgage must have been obtained to buy or build the taxpayer’s principal residence and must be secured by that residence. The “principal residence” is the home the taxpayer lives in most of the time.
- A homeowner can have only one principal residence at a time. Thus, there is no exclusion for vacation homes, second homes, rental property, or business property.
- Unlike the $250,000/$500,000 home sale tax exclusion, a taxpayer is not required to have owned and used the home as his or her principal residence for a minimum of two years.
- Any additional debt incurred by the homeowner to substantially improve the principal residence is also treated as qualified principal residence indebtedness. But a second or other mortgage used for purposes other than improving the main home is not eligible for the exclusion—for example, you can’t exclude debt used to pay off credit cards or to take a vacation.
- If the homeowner refinanced, the debt is eligible for the exclusion up to the amount of the old
mortgage principal just before the refinancing.
The taxpayer must ﬁle IRS Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, to inform the IRS about the exclusion.
Example: Tom Taxpayerʼs main home has a $750,000 recourse mortgage loan (he is personally liable for the loan). Since he purchased the home, it has declined in value to between $600,000 and $650,000.
Tom lost his job and can’t ﬁnd another with a salary large enough to pay his mortgage.
Presented with these facts, Tomʼs lender agrees to allow a short sale of the property for $635,000 and cancels the remaining $115,000 of mortgage debt.
The $115,000 is qualiﬁed principal residence indebtedness that Tom may exclude from income tax.
Exception 2. Insolvency Exclusion
Homeowners who donʼt qualify to have forgiven mortgage debt excluded from income under the qualiﬁed principal residence indebtedness exclusion can still escape being taxed.
Taxpayers donʼt have to include canceled debts in income to the extent they were insolvent immediately before the debt cancellation.
It is likely that most homeowners who can get their lenders to agree to a short sale qualify as insolvent. A taxpayer is insolvent if their total liabilities exceed the fair market value of all their assets immediately before the debt cancellation.
A taxpayerʼs assets include the value of everything they own (including exempt assets beyond the reach of creditors, such as pension plans and retirement accounts). Liabilities include:
- The entire amount of recourse debt (this would include the taxpayer’s total home mortgage debt);
- The amount of non-recourse debt that is less than the fair market value (FMV) of the property that is security for the debt; and
- The amount of non-recourse debt in excess of the FMV of the property subject to the non-recourse debt, to the extent non-recourse debt in excess of the FMV of the property subject to the debt is
Yes, this can be confusing. To help avoid confusion, the IRS has included a worksheet in Publication 4681 that homeowners can use to determine whether they are insolvent.
Example: Tina Taxpayerʼs main home has a $3,000,000 recourse mortgage loan. The home has declined in value to between $2,000,000 and $2,250,000.
Tinaʼs lender agrees to a short sale for $2,150,000 and cancels the remaining $850,000 of mortgage debt.
Tina does not qualify for the exclusion for qualiﬁed principal residence indebtedness because more than $750,000 of debt was discharged.
But she may still exclude the $850,000 from her income if she was insolvent when her lender canceled the debt.
Key Point: The insolvency exclusion doesnʼt apply if the mortgage debt is qualiﬁed principal residence indebtedness, unless the homeowner elects to apply the insolvency exclusion instead of the qualiﬁed principal residence indebtedness exclusion. You make the insolvency election in Part I of IRS Form 982.
Here are ﬁve takeaways from this article:
- Homeowners whose homes have declined in value and who can’t make the mortgage payments can avoid foreclosure by getting their lenders to agree to the sale of the home for less than the amount of the outstanding mortgage—a short sale.
- Lenders that agree to short sales typically forgive a portion of the mortgage loan. Such loan forgiveness constitutes taxable income to the homeowner unless a legal exception applies.
- Forgiveness of non-recourse home loans in short sales does not result in taxable income to the homeowner. Twelve states allow only non-recourse home loans.
- Forgiveness of up to $750,000 in recourse home loans following a short sale is excluded from tax if the mortgage is defined by the tax law as qualified principal residence indebtedness (that is, acquisition indebtedness for the homeowner’s main home).
- Homeowners who don’t qualify for the qualified principal residence indebtedness exclusion can still escape being taxed if they were insolvent when the debt was canceled by their lender. Homeowners qualify for this exclusion if the total of all their liabilities is more than the fair market value of all their assets immediately before the debt cancellation.
From all appearances, the real estate boom appears to be over for now.
As I mentioned, Morgan Stanley predicts that house prices could fall by 10 percent by the end of 2024, perhaps twice as much in a worst-case scenario. Homeowners who purchased their homes at the top of the market could be in trouble, especially if the U.S. falls into a recession.
No homeowner wants to go through foreclosure and its credit rating destruction. Fortunately, there is an alternative: a short sale.
In this article, we present 5 examples of how a Short Sale of Your Principal Residence can benefit you and your financial health.
Typically, a short sale involves forgiveness of part of the mortgage debt owed by the homeowner as debt forgiveness can constitute taxable income to the borrower. If you have any questions, need clarity, or need help understanding how short sales work to maximize your gains to further help retain or maximize your financial security, please contact us at Morris + D’Angelo. This is our Expertise!
At Morris + D’Angelo, we believe that Tax Optimization is one of the most empowering and responsible things you can do to protect your growing financial assets. Tax optimization looks at a multi-year approach to minimizing tax costs. Tax avoidance is integral to tax optimization.
Parts of this article are published with permission from Bradford Tax Institute, © 2021 Daniel Morris, Morris + D’Angelo
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