Mortgage Relief

Tax Consequences of a "Short Sale" / Foreclosure

A short sale is selling the house for less than the mortgage balance with approval of the lender(s) to forgive the unpaid balance—the difference could be taxed as ordinary income to the seller. As to how it is taxed depends on whether the loan is recourse or non-recourse and whether the debt is larger than the Qualified Principal Residence Indebtedness.

Note: The term “short sale” is a real estate term and is not the definition in the IRC. In the tax law, a “short sale” usually refers to selling a security prior to actually purchasing it.

In such situations an appraisal can be used to reduce the tax consequences to the seller, for example, the bank does not do a diligent job of selling the property at a fair market price.

What is debt “recourse” or “non recourse”?

Recourse debt: For recourse debt the sale price is the lesser of the debt cancelled or the fair market value. If the debt is “recourse”, the debtor is personally liable for the debt. Therefore the mortgage company could issue a judgment against the debtor for unpaid debt, attorney fees and other costs.

Non recourse debt: For non recourse debt the sale price is the full amount of the outstanding loan without regard to fair market value. The mortgage company has no recourse but to take the property back and the debtor is not personally liable for the balance.


Note: You should consult with an attorney to determine the status of your mortgage. “Recourse” is determined by State law and by contract. In California, most mortgages to purchase a residence are non-recourse, but mortgages from refinances are usually recourse.

Why a short sale should be considered?

A reason to consider a short-sale instead of a foreclosure is to (1) protect credit rating and (2) have the recourse debt discharge approved in the sale thereby preventing a possible judgment and (3) the new law (HR 3648) protects homeowners with certain recourse debt from cancellation of debt income.

How are foreclosures and short sales taxed?

Non-recourse mortgage
When a non-recourse mortgage is foreclosed, the property is treated as being sold for the balance of the mortgage. For a short-sale, it would be the actual sales price. This is considered a capital transaction—either a capital gain or a capital loss. A capital loss on a principal residence is not deductible, but the gain from a principal residence may be eligible for the $250,000 exclusion per taxpayer.
Example for Non-recourse debt:
Non-recourse debt $500,000
Tax basis in house 300,000
Gain $200,000
If the holding period requirements are met and the residence was a qualified principal residence, the gain would be tax-free.

Exclusion of Cancellation of Qualified Principal Residence Indebtedness under HR 3648
• Must be qualified principal residence as defined under Sec 121 (does not include vacation homes, rentals or investment property).
• Must be acquisition indebtedness as defined under Sec 163. (Includes original or refinanced debt up to “acquisition indebtedness” (i.e. acquisition, construction, or substantial improvement of residence).
• Debt must be secured by principal residence
• Up to $2 million of acquisition debt ($1 million for separate return)
• Use form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, to report the exclusion and the basis reduction.

Important Note: Qualified principal residence indebtedness does not include home equity indebtedness. The Mortgage Forgiveness Debt Relief Act of 2007 does not relieve cancellation of debt income for refinances used to pay off personal debts. Acquisition Indebtedness includes refinancing up to the amount of the loan being refinanced, but not the equity taken out.

Recourse mortgage
For recourse debt, the debt is only satisfied up to the fair market value of the property. There is a sale up to that amount. If the lender forgives the balance of the mortgage, there is cancellation of debt income, which is taxed as ordinary income (Reg Sec 1.61-12)
Example for recourse debt:
Recourse debt $500,000
Fair market value 450,000
Cancellation of debt (ordinary income) $ 50,000
Fair market value $450,000
Tax basis 300,000
Capital gain $150,000

Again, if the holding period requirements are met for a qualified principal residence, the gain would be tax free, but the cancellation of debt would generally be taxable as ordinary income.
If the cancellation of debt income is greater than the property value, then the difference would generally be taxable as ordinary income.

Note: Recourse debt cancellation is not satisfied with the surrender of the property, so any debt not satisfied with the sale proceeds would be taxable as cancellation of debt income (Rev. Rul. 92-99, 1992-2cb 518. Also see Treasury Regulations Sect. 1.1001-2(a)(2).)

Should an appraisal be ordered in this situation? What if the 1099-C that our client receives indicates an artificially low property value, much lower than the amount of debt cancelled? This would cause our client excessive ordinary income to report. Is it possible to do the appraisal if the house had already been foreclosed or had short sale?

Bankruptcy or Insolvency
The exclusions for bankruptcy or insolvency would take precedence over this exclusion provision. Cancellation of debt income in the case of insolvency or bankruptcy is not usually taxable if the debtor is insolvent at the time of forgiveness or has the debt included and discharged in bankruptcy.