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How Short Sales and Foreclosures Affect Your Taxes

Written by a TurboTax Expert • Reviewed by a TurboTax CPAUpdated for Tax Year 2024 • October 16, 2024 1:55 AM
OVERVIEW

If you engage in a short sale or your mortgage lender forecloses on your home, there are some important tax implications that you'll want to consider.

 

Key Takeaways

  • A short sale occurs when your mortgage lender allows you to sell the home for less than your outstanding loan balance and cancels your obligation to repay the remainder of the loan.
  • A foreclosure occurs when your mortgage lender takes possession of your home if you don’t meet the requirements of paying your mortgage.
  • If the lender cancels your outstanding mortgage balance due to a short sale or foreclosure, this debt cancellation may be taxable as ordinary income unless it can be excluded.
  • You may be eligible to exclude up to $750,000 in canceled debt from your taxable income if it relates to qualified principal residence indebtedness for tax years 2021 through 2025.

Selling your home

Whenever you sell a home, you need to calculate your capital gains to determine whether you owe any tax. If you engage in a short sale or your mortgage lender forecloses on your home, the Internal Revenue Service treats it just like a sale. Foreclosures and short sales may also require you to recognize ordinary income if the lender cancels any of your outstanding mortgage balance and you’re ineligible for an exclusion.

Short sales and foreclosures

Both short sales and foreclosures are usually the result of a borrower’s inability to continue making mortgage payments.

A short sale is where your mortgage lender allows you to sell the home for less than your outstanding loan balance and cancels your obligation to repay the remainder of the loan.

With a foreclosure, the mortgage lender will take possession of the home if it doesn’t receive scheduled mortgage payments over an extended period of time.

  • Also, in many cases, the lender cancels your outstanding mortgage balance.
  • Sometimes, this debt cancellation is taxable as ordinary income.

Tax on foreclosures

When your foreclosure includes a cancellation of debt, you only have an obligation to report it as ordinary income if you were personally liable for the entire mortgage, despite the security interest your lender takes in the home.

  • This amount will be reported in Box 2 of a 1099-C that the lender will send you.

You also need to calculate the capital gain that results from the foreclosure. To calculate the gain:

  1. Find your tax basis - generally, the purchase price plus the cost of home improvements you make.
  2. Subtract your tax basis in the home from the home’s fair market value.

However, if you’re not personally liable for debt that remains, use the outstanding mortgage balance at the time of foreclosure instead of the home’s fair market value.

TurboTax Tip:

If you lived in the home and were the owner for a total of two years during the most recent five-year period, you might be able to exclude up to $250,000 or up to $500,000, if filing jointly, of any capital gain that results from the foreclosure.

Gain on short sales

Similar to a foreclosure, any debt that your mortgage lender cancels because of a short sale is taxable only if the terms of your mortgage hold you personally liable for the full amount of the loan.

  • Regardless of the tax consequences, your lender will report the debt cancellation on a 1099-C form.

For example, if you owe $500,000 to your mortgage lender and short sale the home for $450,000, your lender will report $50,000 of canceled debt on your 1099-C.

Since most mortgage lenders wouldn’t agree to a short sale if the value of the home exceeds the outstanding mortgage balance, usually no capital gains issues exist.

Possible exclusions

Through the end of 2020 you may have been eligible to exclude canceled debt from your tax return if it related to qualified principal residence indebtedness and met the requirements of the Mortgage Forgiveness Debt Relief Act. This could have also been applicable to debt that was discharged in 2021, provided that there was a written agreement entered into in 2020.

The Consolidated Appropriations Act (CAA) was signed into law on December 27, 2020 as a stimulus measure to provide relief to those affected by the pandemic. The CAA extends the exclusion of cancelled qualified mortgage debt from income for tax years 2021 through 2025. However, the maximum amount of excluded forgiven debt is limited to $750,000.

Mortgages include those you obtained to buy, build or substantially improve a home and for which the lender retains an interest in the home until it’s paid off.

You may be able to exclude the capital gains as well. If you lived in the home and were the owner for a total of two years during the most recent five-year period, you can exclude up to $250,000 of the capital gains or up to $500,000, if filing jointly, in some cases.

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The above article is intended to provide generalized financial information designed to educate a broad segment of the public; it does not give personalized tax, investment, legal, or other business and professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other business and professional matters that affect you and/or your business.

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