Will I Have To Pay Federal Taxes On The Money My Lender Loses In The Short Sale?

Answer: There are several different scenarios with regard to whether or not you will owe federal income taxes on the loss the lender takes in a Short Sale.

When you do a Short Sale, your lender is agreeing to settled the debt on the property for less than the amount they are owed. The IRS therefore allows them to write off this loss, which is why your lender will send you a 1099-C after the Short Sale.

The IRS considers "debt relief" to be income for tax purposes. In other words, if your lender writes off $50,000 on your Short Sale, they will send your a 1099-C for that amount, and you would include that when you file your income taxes. The "C" stands for "Cancellation of Debt" and the law says canceled debt is a taxable as income.

There are however a few exceptions that most people who do a Short Sale qualify for that exclude them from having to pay taxes on their Short Sale.

Thanks to the Mortgage Tax Debt Relief Act that George W. Bush signed into law in January 2008, homeowners who do a Short Sale on their primary residence, and have a purchase money loan (in other words, they have not pulled cash out of their home with a cash-out refinance) pay no taxes on the loss that their lender incurs in a Short Sale.

All other Short Sale scenarios-if you pulled cash out on your primary residence but spent it something other than upgrading your home or if you are doing a Short Sale on a second home or investment property-result in a taxable event unless your qualify for the "Insolvency" exclusion.

The IRS does not required you to pay taxes on the loss the lender takes in a Short Sale, if at the time of the Short Sale, you are insolvent. Insolvency means your debts (including your mortgage) exceed the value of all your assets. In other words, if, at the time of the Short Sale, you have more debt than you do money or assets, you are considered insolvent.

Many people who find themselves facing a Short Sale are in exactly this situation and are thus excluded from paying taxes on a Short Sale. We recommend you check with your CPA or accountant or go to the IRS website and look up IRS Form 982, which is the IRS form for debt relief and Short Sales. The IRS gives and explanation of "Insolvency" on this form.

Finally, the time period for The Mortgage Tax Debt Relief Act was originally only slated to go until the end of 2008. however it has now been extended to the end of 2012.