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Short Selling and Your Taxes

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TERMINOLOGY

Short selling is the process by which a homeowner sells his home for less than his outstanding loan balance with the approval of his lender. Depending on your situation, a short sale may have considerable tax consequences.

Taxable Income

The IRS considers forgiven debt taxable income. If you agree to pay your lender the deficient amount of the loan balance after the short sale, the process won’t impact your tax obligations. If, however, your lender opts to forgive the balance and claim it as a tax loss, the IRS may hold you responsible for paying taxes on the deficient amount of the loan.

Mortgage Debt Forgiveness

The Mortgage Forgiveness Debt Relief Act, valid through December 31, 2012, absolves homeowners from paying taxes on mortgage deficiencies incurred through short sales or foreclosures on a primary residence. If your short sale was for investment property or a rental home, however, you are liable for paying taxes on a forgiven short sale deficiency.

Tax Relief for Second Homes

If you negotiate a short sale on a home that you used as a second residence, you must still pay taxes on the forgiven debt, but you can deduct a portion of the debt depending upon the amount of time you lived in the house during the given tax year. This provides a measure of tax relief for individuals who commute between two residences or own vacation property.