Do You Understand the "Short Sale"?

Short sales are becoming more of a topic as overburdened investors look to relieve themselves of top heavy mortgage obligations. Savvy investors know to be aware of possible tax liabilities and the effect short sales have on your credit rating.

Homeowners will need to consider the effect a short sale will have on their credit rating. A lender will typically report a short sale transaction to the credit bureau. While it may be better than a foreclosure, a short sale will definitely leave a considerable mark on your credit report.

Short sales occur when a lender accepts an amount less than the amount mortgaged as the total payment to settle the debt obligation. Essentially the lender allows the homeowner to sell his or her property for less than what is owed on the mortgage. For example, let's assume your mortgage is $200,000 and you have fallen behind on your mortgage. You decide you need to sell your home to be relieved of the remaining mortgage. Your real estate agent tells you based upon recent sales in your area that similar properties sell for $170,000 today.

The problem is that the homeowner who sells their home in a short sale may face a considerable tax bill based on the amount of the mortgage balance. Having the lender forgive the debt does not lessen the tax liability. The property will be taxed as if it were sold for the total outstanding amount of the loan, or the sale price, whichever is higher. If the bank were to forgive the $30,000 deficit the money will be reported to the IRS as cancelled mortgage debt on your behalf.

Short sales are considered by the IRS to be a debt cancellation. Your Bank will send you an IRS Form 1099C-Cancellation of Debt. The IRS views the cancelled or forgiven mortgage as income to the borrower in the tax year the debt was cancelled. You may end up with a large and unexpected tax bill on April 15th of the next year.

Banks don't always agree to short sales and generally will not consider one too early in the process. Short sales are easier to negotiate if you already have a purchase contract from a qualified buyer. The Bank will make its decision based upon a number of factors including the best interest of the depositors and the hardship of the homeowner. Homeowners are required to prove that they are insolvent in an audit like process that can take weeks or months to complete.

The taxability of the gain and deductibility of the loss depend on the nature of the property. The loss may be tax deductible if your property is a rental property. Talk to your tax adviser to see what options are available to you.