Tax consequences of a short sale of your principal residence

By
Industry Observer with Green Krist CPA PLLC 34463

The real estate boom appears to be over for now.

Morgan Stanley predicts that house prices could fall by 10 percent by the end of 2024, perhaps twice as much in a worst-case scenario. Homeowners who purchased their homes at the top of the market could be in trouble, especially if the U.S. falls into a recession.

No homeowner wants to go through foreclosure and its credit rating destruction. Fortunately, there is an alternative: a short sale.

In a short sale, homeowners sell their home in a regular sale through a real estate agent for less than the amount of their mortgage. The lender accepts the sale proceeds, releases the mortgage lien on the property, and typically writes off the remainder of the loan as an uncollectible debt.

Lenders agree to short sales only where it’s clear that

  • the home is worth less than what the homeowner owes, and
  • the homeowner is financially unable to keep up the mortgage payments due to job loss, health issues, death, or other hardship circumstances.

Typically, a short sale involves forgiveness of part of the mortgage debt owed by the homeowner. Debt forgiveness can constitute taxable income to the borrower. Whether the debt forgiven in a short sale is taxable income depends on several factors, including whether

  • the mortgage is a recourse or a non-recourse loan,
  • the forgiven debt qualifies for the qualified principal residence indebtedness exclusion, or
  • the homeowner was insolvent at the time of the debt cancellation.

Forgiveness of a non-recourse loan (a loan for which the borrower is not personally liable) does not result in taxable income to the borrower. Twelve states allow only non-recourse home loans.

But recourse loans are standard practice in the other 38 states.

Fortunately, for underwater homeowners who have recourse loans, Congress passed the Mortgage Forgiveness Debt Relief Act in 2007. Thanks to this law, up to $750,000 of “qualified principal residence indebtedness” forgiven by a lender is excluded from tax. This exclusion remains in effect through 2025 and applies only to debt to acquire or build the taxpayer’s principal residence.

Homeowners who don’t qualify for the qualified principal residence indebtedness exclusion can still avoid paying tax on their canceled indebtedness if they were insolvent when the debt was canceled. Taxpayers are insolvent if their total liabilities exceed the fair market value of all their assets immediately before the debt cancellation. It’s likely that most homeowners who can get their lenders to agree to a short sale qualify as insolvent.

Green Krist, CPA  specializes in assisting taxpayers with IRS and North Carolina Department of Revenue issues in the greater Raleigh, North Carolina area.

Comments (4)

Will Hamm
Hamm Homes - Aurora, CO
"Where There's a Will, There's a Way!"

Hello Kelly and great information to share with us here in the Rain.  Make it a great Sunday!

 

Jan 29, 2023 07:47 AM
Michael J. Perry
KW Elite - Lancaster, PA
Lancaster, PA Relo Specialist

Isn’t it Time to make The Mortgage Forgiveness Act a permanent part our Federal Tax Code ?!!

Jan 29, 2023 09:08 AM
Bill Salvatore - East Valley
Arizona Elite Properties - Chandler, AZ
Realtor - 602-999-0952 / em: golfArizona@cox.net

Happy Sunday, sit back this afternoon and enjoy two great football games.  I will be rooting for San Fran because the rookie QB Brock is from my City, Gilbert Arizona.  Also, the Bengal's. Bill 

Jan 29, 2023 11:54 AM
Joe Jackson
Keller Williams Capital Partners Realty - Columbus, OH
Clintonville and Central Ohio Real Estate Expert

This is an excellent post with great information. Thanks for sharing it.

Have a super fantastic week!
Joe Jackson, Realtor-KWCP

Jan 30, 2023 05:14 AM