A short sale is a way for an individual to sell their home if they are unable to pay their mortgage. If the banks agree to shorten their home at a lower price than their mortgage, they will forgive a portion of their mortgage. The IRS considers canceled debt income.
The “Mortgage forgiveness debt relief Act” no longer penalizes homeowners who short sell their primary residence. This law allows homeowners to exclude from taxes up to $2,000,000 in debt that has been canceled for their principal residence. You must meet the following requirements to be eligible under the Mortgage Forgiveness debt relief Act and exempt canceled debt from your short sale.
- Get the debt canceled from the short-sale sale of your principal residence
- You borrowed the money to purchase, build, or substantially improve your principal residence.
If you short-sale your rental property/vacation home/second residence, the Mortgage Forgiveness Debt relief Act doesn’t apply. There is also no relief for home equity loans or cash out to refinance mortgages unless the proceeds were used to improve your home.
If you are not covered by this law, the debt canceled will be subject to tax liability. Canceled debt can be considered income and taxable. If your total debt exceeds your assets (aka insolvent), you may be eligible for an exemption from your tax liabilities. You will need to prove insolvency using the IRS Form 982: Reductions of Tax Attributes due to Discharge of Indebtedness.
This article was written by Alla Tenina. Alla is one of the best tax attorneys in Los Angeles California, and the founder of Tenina law. She has experience in bankruptcies, real estate planning, and complex tax matters. The information provided on this website does not, and is not intended to, constitute legal advice; instead, all information, content, and materials available on this site are for general informational purposes only. Information on this website may not constitute the most up-to-date legal or other information. This website contains links to other third-party websites. Such links are only for the convenience of the reader, user or browser; the ABA and its members do not recommend or endorse the contents of the third-party sites.