Understanding how a short sale or restructure will be viewed by the Internal Revenue Service can help you plan your tax situation ahead of time.
If you are in a position where you have to sell your house for less than the amount you owe on it or have to restructure your mortgage with the lender in order to avoid foreclosure proceedings, you may face tax implications on the transaction. Understanding how a short sale or restructure will be viewed by the Internal Revenue Service can help you plan your tax situation ahead of time.
What is a short sale?
A short sale happens when you sell your property for less than what you owe on its mortgage(s). A short sale has to be approved by your lender because it will not receive the full amount of the outstanding loans.
After the sale, the loan will still have an unpaid balance, called the deficiency. Depending on the lender and the laws of your state, a short sale can result either in you owing the deficiency to the lender as unsecured debt, or in the lender forgiving the deficiency. A short sale is often negotiated as an alternative to foreclosure, as it often involves fewer costs and fees.
Tax implications of forgiven debt
If your lender forgives the balance of your mortgage after the short sale, you may not be out of the woods yet. You may have to include the forgiven debt as taxable income in the year of the short sale. The Mortgage Forgiveness Debt Relief Act of 2007 and its extensions exempts that income through 2020 from taxation, up to $2 million, if it was your principal residence, or main home. However, the tax still applies to second or vacation houses as well as rental properties.
Beginning in 2021, the exemption is no longer available. However, this can apply to debt that is discharged in 2020 provided that there was a written agreement entered into in 2020.
Before seeking a short sale or being forced into a foreclosure, you may be able to negotiate a mortgage restructuring to allow you to stay in your home and to be more able to afford your mortgage's terms and interest rate. These types of loan modifications can take many forms and may include:
- Reduced interest rates
- A reduction of the loan principal
- Stretching out the payments over a longer time frame to make payments smaller
Of these options, only a principal reduction may have income tax implications. The principal reduction may be considered taxable income to you in the year of the restructure. If the property is your main home, it will fall under the provisions of the Mortgage Forgiveness Debt Relief Act and will be excluded from taxable income.
Dealing with incorrect 1099-C forms
If your lender has reduced or eradicated your debt under a short sale or mortgage restructure, it will send you IRS Form 1099-C at the end of the year, showing the amount of the debt forgiven and the fair market value of the property. Review the document carefully and compare it to your own figures. If it contains misstatements, contact the lender and attempt to have it correct the form. If it is not able, or not willing, to do that in a timely manner, recalculate the correct figures and provide the IRS with documentation showing how you arrived at your figures when you file your income tax return.
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