What possible tax issues might I have with a short sale?

The income tax issue resolves around forgiven debt in the short sale of a home.

Any time a debt is forgiven, the creditor will generate a “debt forgiveness” 1099 for the debtor. This is true whether the forgiven debt is unsecured credit or a mortgage loan.

The IRS requires all financial institutions to generate a debt forgiveness 1099 regardless of whether the taxpayer will be required to pay Federal Income Tax on the forgiven debt. So when you receive this document, don’t panic.

In general, if the debt was a home mortgage, it’s likely that you won’t owe the tax. However, there are qualifications in the law, so don’t assume anything.

Following is an overview of the rules.

Please do read the indicated IRS publications and seek specific advice from your own tax accountant or attorney.

Tax consequences of the short sale of your primary residence under Internal Revenue Code Section 121:

The San Diego short sale homeowner can find some basic information on the Mortgage Debt Relief act of 2007 at IRS.gov. This Act was set to expire on December 31, 2012, but has been extended several times. It now expires on December 31, 2016. Will it be extended again? We don’t know, but judging from past performance, we may not find out until late into 2017.

Generally, the Act allows taxpayers to exclude income from the discharge of debt on their principal residence. You will be required to acknowledge the 1099 on your Federal Tax Return, but will then file another form to offset the liability.

Debt reduced through mortgage restructuring, debt forgiven during the short sale of a home, and mortgage debt forgiven in connection with a foreclosure all qualify for the relief.

Short sale on San Diego rental property

IRS Form 982 is used to reduce the liability of a tax attributed to the sale of a property that results in a loss. See Section 108 of the IRC. The seller of a rental property needs to be prepared to use this option to avoid tax liability, if any. Section 108 specifically qualifies real estate for business purposes and paves the way for the tax payer to avoid liability for phantom income associated with rental property.

The second home short sale dilemma

The second home presents a true issue with regard to short sale and tax planning. The borrower who needs to go into a short sale on a second home should seek tax counsel and explore whether the property might be converted into rental property and qualify under the example above for rental properties under Section 108.

The IRS and cancelled debt

For more information on the IRS and cancelled debt, refer to IRS Publication 4681: Canceled Debts, Foreclosures, Repossessions, and Abandonments – specifically the sections on Qualified Real Property Business Indebtedness and Qualified Principal Residence Indebtedness.

Consideration of a short sale does bring about questions… call 619-929-1413 or write td@tomdunlap.com to get specific answers to your short sale questions.


Please note that the information provided on this San Diego short sale page is generic, academic information used for general information purposes and may not be construed as or relied upon as a promise for a specific outcome.

This site provides information about real estate, law, income taxes and credit scores as relates to borrowers in distress, short sales and similar situations. The site is designed to help users safely cope with their own needs. Information is not the same as advice — the application of law or regulations to an individual’s specific circumstances. Although we go to great lengths to make sure our information is accurate and useful, we recommend you consult a lawyer, tax adviser or other specialist if you want professional assurance that our information, and your interpretation of it, is appropriate to your particular situation. The models in photographs accompanying the testimonials on this website are used for illustrative purposes and are not a personal endorsement.