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Short Sales and Their Tax Consequences

Is a Short Sale Right for Me?

In order to answer this question, we must first explain what is meant by a short sale. A short sale is a sale of one’s real estate for less than is owed on the mortgage. In order to accomplish this, the mortgage company must agree to accept less than its full balance. A short sale cannot be accomplished without the consent of the creditor.

A short sale is probably a good idea to consider if you owe more on your house than it is worth and cannot afford the mortgage payments. However, In order for a short sale to be beneficial, the short sale should be accompanied by a full release of personal liability, or at least by a significantly reduced balance on the amount of debt left over after the sale. Many times a mortgage company will agree to a short sale but will not release the borrower from personal liability or offer any type of restructuring or forgiveness of the remaining balance. This means that the creditor will still be able to collect the “deficiency balance” from the borrower. (Although some states prohibit collection of these balances, both Kentucky and Indiana permit creditors to collect deficiency balances).This type of short sale benefits only the buyer (who probably got a good deal on the property) and the real estate agent who got a commission for arranging the deal. Real estate agents love short sales because it is a way for them to earn extra money, so be wary of real estate agents trying to talk you into a short sale which may not be in your best interest.

What are the tax consequences of a short sale? Prior to 2007, a short sale accompanied by a release of personal liability created taxable income to the borrower. For example, if you owed $150,000 on your house and sold it for $100,000.00, with the mortgage holder agreeing to release you from the balance, the $50,000 forgiven would be treated as taxable income for that year. However, The Mortgage Debt Relief Act of 2007 provides that debt reduced through mortgage restructuring, as well as mortgage debt forgiveness, is excluded from income. Up to $2 million of forgiven debt is eligible for this exclusion or $1 million if married but filing separately. The exclusion only applies to property that is the individual’s primary residence, not rental properties. Furthermore, the exclusion does not apply if the release of the debt is due to services performed for the lender or any other reason not directly related to a decline in the house’s value or the taxpayer’s financial condition.

Before agreeing to a short sale, one should consult with a competent tax professional in order to assure that the transaction meets all of the requirements of The Mortgage Debt Relief Act of 2007 in order for the forgiven debt to be excluded from income. Keep in mind that this law does not apply to forgiveness of other types of debt such as credit cards.

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