If I Short-Sale my house will there be tax implications?

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UPDATE: 12-20-07 The Senate passed (93 to 1) a bill which would end, but only for three years, a provision in the tax code which has haunted so many homeowners after foreclosure, loan workout or short sales. The Internal Revenue Service requires mortgage companies to send borrowers a 1099 for any loan amount written off by the lender after a foreclosure, short sale, or loan restructure. The IRS treats that forgiven debt as income and taxes the borrower accordingly. I often get asked that question... Will I have to pay taxes on the amount the bank writes off on my short sale?

The answer is NOT a simple one, it depends on the situation. Legislation is currently being proposed that will further simplify the issue, but in the mean time, there are many cases where you WILL NOT have a tax liability.

#1 - Not all lenders actually issue a 1099 to their borrowers.

#2 - More debt than assets? The tax could be eliminated anyway.

Here is the response by a well respected CPA on this issue:

According to IRS Publication 908, Bankruptcy Tax Guide, income from cancellation of debt can be excluded from income on an individual's tax return if the cancellation takes place when the individual is insolvent.

Insolvency is when an individual's liabilities exceed their assets. Determine your liabilities and your assets immediately before the cancellation of your debt to determine whether or not you are insolvent. Most people in foreclosure are insolvent.

If you short sold your house and your lender did give you a 1099 for the amount forgiven, a form 982 needs to be attached to your tax return. This shows that the cancellation of debt income is being excluded.

Contact your own CPA for more information.

Sept. 17, 2007 - TAX UPDATE:

Special Web Section Unveiled for Homeowners Who Lose Homes; Foreclosure Tax Relief Available to Many

IR-2007-159, Sept. 17, 2007

WASHINGTON -- The Internal Revenue Service unveiled a special new section today on IRS.gov for people who have lost their homes due to foreclosure. The IRS also reassured homeowners that, although mortgage workouts and foreclosures can have tax consequences, special relief provisions can often reduce or eliminate the tax bite for financially strapped borrowers who lose their homes. The new section of IRS.gov includes a variety of information, including a worksheet designed to help borrowers determine whether any of the foreclosure-related relief provisions apply to them. For those taxpayers who find they owe additional tax, it also includes a form they can use to request a payment agreement with the IRS. . In some cases, eligible taxpayers may qualify to settle their tax debt for less than the full amount due using an offer-in-compromise.

The IRS urges struggling homeowners to consider their options carefully before giving up their homes through foreclosure.

Under the tax law, if the debt wiped out through foreclosure exceeds the value of the property, the difference is normally taxable income. But a special rule allows insolvent borrowers to offset that income to the extent their liabilities exceed their assets.

The IRS cautions that under the law, relief may be limited or unavailable in some situations where, for example, part or all of a home was ever used for business or rented out.

Borrowers whose debt is reduced or eliminated receive a year-end statement (Form 1099-C) from their lender. By law, this form must show the amount of debt forgiven and the fair market value of property given up through foreclosure. Though the winning bid at a foreclosure auction is normally a property's fair market value, it may not necessarily reflect its true value in some cases.

The IRS urges borrowers to check the Form 1099-C carefully. They should notify the lender immediately if any of the information shown on their form is incorrect. Borrowers should pay particular attention to the amount of debt forgiven (Box 2) and the value listed for their home (Box 7).

The IRS also reminds lenders of their obligation to provide accurate information on the Form 1099-C. By law, the lender must send a copy of this form to the IRS. IRS follow-up contacts with taxpayers involved in foreclosure are based largely on the information reported on this form, and whether it conflicts with information provided by the taxpayer on their federal income tax return.

The IRS normally initiates these follow-up contacts by sending the borrower a notice. The tax agency urges borrowers with questions to call the phone number shown on the notice. The IRS also urges borrowers who wind up owing additional tax and are unable to pay it in full to use the installment agreement form, normally included with the notice, to request a payment agreement with the agency.