What are the Tax Implications of a Short Sale?

The tax implications of a short sale, in which a person struggling to pay their mortgage sells his property for less than it is worth, can be substantial. This is because the forgiveness of the debt that accompanies this process is considered to be taxable income for the seller. As a result, the tax implications of a short sale are damaging for home sellers who aren't aware of their obligations. In the United States, a 2007 act of Congress has lessened this financial burden by allowing a significant tax exemption for those people executing a short sale.

There are very few options at times for those people who have fallen way behind on their mortgage payments, but a short sale can be an effective way to remedy this problem. It can provide benefits to the mortgage lender, who receives some sort of return on a property that might have been difficult to sell if it had been foreclosed. In addition, the new buyer often gets a home at a reduced price. The seller gets out of his debt, which helps to preserve his credit rating, but he also must be aware of the tax implications of a short sale.

To understand the tax implications of a short sale, an example is helpful. Imagine that a person owes $800,000 US Dollars (USD) on a home to a lender. The lender, wanting to avoid the costs associated with foreclosing and get some of its investment back, agrees to allow the lender to make a short sale. As a result, the person selling the home finds a buyer willing to pay $600,000 USD, a price that proves to be agreeable to all parties.

What the person executing the sale needs to understand is that the tax implications of a short sale demand that some restitution be made for the forgiveness of debt. In this case, the forgiveness of debt is $800,000 USD, the amount owed on the home, minus the $600,000 USD sale price. That amount comes to $200,000 USD, and the lender will send tax documents to the borrower that specify the tax obligations on this amount.

In the United States, a recent law enacted by Congress gives some measure of relief to those suffering the tax implications of a short sale. The Mortgage Forgiveness Debt Relief Act, passed in 2007, allows those executing a short sale an exemption of up to $2 million USD for any debt relief provided by their lenders. It must be noted that this exemption is applicable only if the property in question is the principal residence of the seller.