How to Report Short Sales On Taxes

How to Report Short Sales On Taxes

All debt forgiven in a short sale was taxed as ordinary income prior to the adoption of President George W. Bush’s "Mortgage Forgiveness Debt Relief Act and Debt Cancellation" in 2007. What you owe the lender and what the house was sold for is therefore treated as income for the tax year. The Mortgage Forgiveness Debt Relief Act, however, changed that. Begging 2007 through 2012, taxpayers will be allowed to exclude debt forgiven from the short sale of a principal residence.

Understanding Short Sale

If you sell your home for less than the total debt balance remaining on the mortgage and the lender agrees to receive the gains from the sale releasing the lien on the property in return, this transaction is called a short sale. Foreclosures are avoided when borrowers do a short sale.

The lender will have the ability to come after you for a deficiency judgment after a short sale. If the lender decides to forgive the deficiency, you may owe taxes to the Internal Revenue Services.

What happens if the lender pursues a deficiency?

Let us first understand what “deficiency” really means. A short sale happens when the sale price is “short” of the amount you owe to the mortgage lender. Deficiency is the difference between the total debt owed and the sale price.

Here’s a quick example: You are selling your property for $200, 000, as approved by your lender, but you really owe them $250, 000. The deficiency, in this case, is, therefore, $50, 000.

In general, as soon as the lender gets a deficiency judgment, the deficiency amount we have in our example, $50, 000 will be collected from the borrower through normal collection methods. These methods include garnishing the borrower’s wages or levying the borrower’s bank account. A lot of these cases happen wherein some lenders seek a personal judgment against you after the short sale to get the deficiency amount back.

What are the tax implications if the lender “forgives” the deficiency?

You may be forgiven by the lender by issuing you a 1099-C, Cancellation of Debt Form. It is when the lender decides to forgo pursuing a deficiency judgment to forgive the deficiency amount.

Here’s what you should do:

1. You should be able to receive the Form 1099-C, Cancellation of Debt by Feb 2 in the year following the short sale. You just have to wait for it in the mail. If nothing arrived in your mail, contact the lender and request a copy. Box 2 will contain the amount of debt that was canceled in the short sale.

2. Look for the IRS Form 982, "Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment)." You can download this form from the website of the IRS or you will also find it in many tax software programs.

3. Once you received the form, look for the spaces provided for you to enter your name and tax identification number which is found at the top of the form.

4. Find the box to the right of line 1e, "Discharge of qualified principal residence indebtedness," on IRS Form 98 and put a checkmark to it.

5. Use the amount from Box 2 on the 1099-C form you received from the lender and fill out line 2, "Total amount of discharged indebtedness excluded from gross income," on Form 982

6. Last but not the least, attached the completed IRS Form 982 to your federal tax return.

Is there any short sale tax penalties?

There are no short sale tax penalties, however, you do need to keep two important things in mind:

  • Report your property sale in the same year you do the short sale after receiving a Form 1099-S, Substitute State like Form 1099-A.
  • You may need to deal with cancellation of debt income as explained above
  • If you claimed a first-time homebuyer credit, the sale must be reported.

When reporting your property sale in the year of the short sale, make sure you report residences, personal-use property, and investment property, on Schedule D.

Using Form 4797, report business and rental property and calculate your gain or loss by subtracting your adjusted basis in the property from the sales price. The sales price will be determined base on if you’re personally liable for the loan. Did you have a recourse loan or a nonrecourse loan? Ask your lender this question.

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