Lesson#7 - What are the Tax Consequences of a Short Sale?

DISCLAIMER:  The following is not tax advice.  Please consult a licensed tax professional for any tax related questions.

Are there any tax consequences triggered from doing a short sale?  Unfortunately, there can be.  Our beloved Internal Revenue Service (IRS) has a rule that when any lender forgives a borrower more than $600, the total amount forgiven is to be reported to the IRS in the form of a 1099C Forgiveness of Debt.  In short sale terms, what that means is that when a lender agrees to a short sale, if they decide to forgive the borrower what they lost, they are required by the IRS to send a 1099C in the amount of that loss.  If you have ever been paid money and in January receive a 1099 in the mail for the amount you earned, you’ll be able to relate to how large the tax liability can be and the amount of income taxes you have to pay on a 1099.  It’s not fun. 

You may be scratching your head in bewilderment as to how the IRS could recognize debt forgiveness as income because you as the borrower never saw a dime of that money in your bank account.  As unfair as that may be, the tax consequences of a short sale could be that the lender issues the borrower a 1099C in the amount of the loss.

Now that you are completely panicking, I have some good news for you.  There are two different forms of tax liability relief for borrowers who are going through a short sale.  The first “get-out-of-jail-free-card” for borrowers doing a short sale is the Mortgage Forgiveness Debt Relief Act of 2007 which provides a way for borrowers to avoid the tax liability triggered by the 1099C Forgiveness of Debt Form (so long as the property has been their primary residence).  There are some additional restrictions that apply so borrowers should always consult a competent tax advisor before assuming they are free from any tax consequences from a short sale on their primary residence.  However, this little piece of legislation has been a wonderful tax consequence gift for many borrowers the past few years. 

But what about doing short sales on investment properties, real estate that is not a primary residence?  That’s what the next tax relief strategy covers.

The second way to maneuver around the tax consequences triggered by a short sale is if the borrower can be recognized as “insolvent” at the time the short sale was closed.  This is a little known part of the IRS tax code, “Insolvency,” which allows borrows to avoid paying income tax on any 1099Cs that are triggered from losses so long as they were flat broke when those 1099Cs were triggered.  There are quite a few restrictions to qualify for insolvency so you certainly need to communicate with a tax expert who understands it.  This second tax liability relief strategy is ideal for those who are doing a short sale on a non-owner occupied investment property.  It was originally created to help those who filed bankruptcy and then at tax time would be “kicked while down” and required to pay income tax on the losses the lenders incurred from the bankruptcy.  Smart tax professionals can use this same loophole to help those who have done a short sale on an investment property. 

The only way in which a short sale does not trigger any tax consequences is when the lender does not “write off” the loss or forgive the borrower, but instead, opts to hold the borrower responsible for the loss.  This is often the case when a property goes to foreclosure.  That’s one of the many reasons why a short sale is far better than a foreclosure.  If the lender holds the borrower responsible for the loss, a 1099C Forgiveness of Debt form is not issued, but instead, the lender pursues the borrower for the lost money.  They may, at that point, file a judgment with the courts, which then makes the situation a lot whole uglier than it already is.  To me, that is a much more destructive outcome.  The Mortgage Forgiveness Debt Relief Act of 2007 and Insolvency make the tax consequences of a short sale far easier to deal with than when the lender holds the borrower responsible for the difference.  And the only way to have a fighting chance at preventing the lender from holding the borrower responsible for the difference is to do a short sale.