On Real Estate: Short-Selling Comes With Tax Implications

There are many realtors and short sale negotiators that are well versed in helping their clients through the complicated selling process. But sellers need to be aware of how to protect themselves from future liability and what to expect before agreeing to lender conditions.

Sellers generally assume that they can walk away from their home and automatically be relieved from any future responsibility for any mortgage debt not covered by the sale of the home. This may not necessarily be the case. Any debt that is forgiven by a lender is still considered income to the borrower and a tax could still be owed on that portion.

A law enacted in December 2007 provides relief to troubled borrowers when some portion of mortgage debt is forgiven. That relief expires on Dec. 31, 2012. This legislation ensures that homeowners are not obligated to pay tax on income that the homeowner has not received.

A borrower can be excused from paying tax on forgiven mortgage debt, but the debt must be secured by a principal residence and the total amount of the outstanding obligation may not exceed the original mortgage amount plus the cost of any improvements.

The relief provision can also apply to a refinanced mortgage but the same conditions apply. Tax relief is generally not available for second mortgages or home-equity lines of credit where the funds are not used for home improvement. Any amount that is not eligible for the relief provision will be taxed as ordinary income.

Many homeowners have been able to take advantage of new options that provide a means to work out an arrangement with a lender to reduce the principle balance of a mortgage. The amount of the reduction will not be taxed.

The lender is required to provide the homeowner and the IRS with a Form 1099-C reflecting the amount of the forgiven debt. The borrower must then file a Form 982 to reflect the amount forgiven and to show the reason why the forgiven amount is not taxable. Any taxable portion of forgiven debt will then be reported on the homeowner’s Form 1040 for the tax year in which the debt was forgiven

Forgiveness of debt is always at the lender's discretion. In order to verify that a lender has forgiven the debt, the lender must specifically state the amount forgiven in the short sale conditions. It would be wise for all homeowners to obtain legal counsel before the short sale is listed to make sure the final paper work has no deficiency clause and to help in filing any necessary tax forms.

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Joan Probala is the managing broker for Issaquah Windermere, with 30 years of experience in real estate, construction and sales, and is president-elect of the Seattle King County Association of Realtors.