Short Sale – Tax Nightmare?

I am selling my house via a short sale.  Will I have to pay tax on the forgiven debt?

 Under the Mortgage Forgiveness Debt Relief Act of 2007, enacted December 20, 2007, taxpayers may exclude debt forgiven on their principal residence.  This provision applies to debt forgiven in calendar years 2007 through 2012. Up to $2 million of forgiven debt is eligible for this exclusion ($1 million if married filing separately).  Details are on Internal Revenue Service (IRS) Form 982 and its instructions, available on  Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, may qualify for this relief.  In most cases, eligible homeowners only need to fill out a few lines on IRS Form 982 (specifically, lines 1e, 2 and 10b).

 What are some of the rules?

The debt must have been used to buy, build, or substantially improve the taxpayer’s principal residence and must have been secured by that residence.  Debt used to refinance qualifying debt is also eligible for the exclusion, but only up to the amount of the old mortgage principal, just before the refinancing.  Debt forgiven on second homes, rental property, business property, credit cards or car loans does not qualify for this tax-relief provision.  In some cases, however, other kinds of tax relief, based on insolvency, for example, may be available.

Will the government extend forgiveness? 

It is possible that the federal government may extend the principal residence short sale tax forgiveness beyond December 31, 2012.  It is also possible that the government may not extend this provision.  The government needs tax revenues and 2012 is an election year, which may affect political decisions.  Given what we know now, people who are considering a short sale of their principal residence are better off if they sell their house in 2012.

 Can the mortgage lender come after me?

Please be advised that your mortgage lender might not agree to forgive the mortgage deficiency. If they do not forgive the deficiency, they may legally pursue you personally to collect this debt.

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