Will I Have An Income Tax Liability If I Do A Short Sale?

As of this writing (January 22, 2014), unfortunately the answer to that question is more than likely YES!

Therefore, anyone considering a short sale at this time needs to be aware of potential tax consequences.

In 2007, President Bush signed into law the Mortgage Forgiveness Debt Relief Act. The law pertained to mortgage and other debts that could be discharged for calendar years 2007 through 2009. The law was subsequently extended to December 31, 2013. Unless it is hereafter renewed (and hopefully made retroactive to January 1, 2014), unless you met certain very specific requirements, the law may no longer provide you any tax benefit.

In a short sale, your lender agrees to accept an amount less than the total due on your loan. Any amount not required to be repaid may (or may not) be agreed to be forgiven by your lender. However, forgiven debt may still be considered income by the IRS. Thus, should you, for example, get your lender to forgive all or part of what you may actually owe, the IRS may still expect you to report this forgiven amount and pay income tax on it! You may thus have to pay tax upon money you never actually received!

A short sale, where you are able to obtain a release from any possible deficiency, is a great thing. However, unless the Mortgage Forgiveness Debt Relief Act is reinstated, or you satisfy certain tax exceptions or exemptions, watch out for potential tax liability, especially where you may not be able to discharge such obligation should bankruptcy become necessary.