Do You Have an Underwater Mortgage? You May Owe the IRS After a Short Sale

One of the more surprising (and unpleasant) aspects of the tax code is the "forgiveness of indebtedness rules." Basically, when a debt or a portion of debt is forgiven, the avoided obligation is considered "income" and subject to income tax. During the housing crisis, this was as a serious problem for those home owners who sold their houses in a short sale.

Short Sale Could Result in Loss and a Large Tax Bill

A short sale occurs when the proceeds of a sale of property are insufficient to pay the mortgages encumbering the property in full. In such circumstances, many banks will accept less than they are owed and write off the balance. That write off is a forgiveness of indebtedness, which is then subject to tax. For example, let's say your house is worth $400,000 and you owe $500,000 on your mortgage. If the bank agrees to release your loan for $400,000, you have $100,000 in "income" (i.e. the forgiveness of the remaining debt) which is now subject to tax; thus creating a double-whammy in which you are selling your house at a big loss AND generating a big tax bill.

Recognizing the inherent unfairness to struggling homeowners, given the swiftness and severity of the downturn in the housing market, Congress passed The Mortgage Debt Relief Act of 2007, which, in most circumstances, allowed forgiven mortgage debt to be excluded from income for tax purposes. The law, however, expired as of December 31, 2013, and as of now, Congress has not passed any extension of the law. Without any extension, short sellers now have to take into consideration the income tax ramifications of a short sale, which could make it more difficult to bring these transactions to a close.

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