Photo: Alan Cleaver
When you ask your lender to accept a short sale on your home you are asking them to take less money than the outstanding loan balance on that property. This is commonly referred to as a short sale, and you may experience two main consequences:
- If you were late in making payments your credit score could drop anywhere from 60 to 300 points depending on how late you were; and
- You may receive a form 1099-C from your lender, which can have tax consequences.
Let’s look at an example of a short sale:
Say you bought your home 3 years ago for $200,000. You were able to get a first loan of $190,000. Now you’re in a situation where you need to sell the home, but can only do so for $150,000. You owe the lender $190,000, but can only get $150,000, and you don’t have the $40,000 in cash to make the lender whole. Thus you ask them to accept the short sale as payment in full. When they agree, you’re out from under the loan, and free to move on. Or so you think…
Whenever you payback a mortgage for less than the outstanding balance the lender can issue a 1099-C for cancellation of debt. When you borrowed the money you were not required to include the loan proceeds in income because you had an obligation to repay the lender. When that obligation is subsequently forgiven, the amount you received as loan proceeds is reportable as income because you no longer have an obligation to repay the lender. In the example above, you would be reporting $40,000 as income from the cancellation of debt.
Fortunately, that may sound worse than it actually is. There are some situations in which you would be exempt from paying taxes on that gain. The Federal Bailout Legislation H.R. 1424, passed on October 3, 2008, stipulates that if you have owned and used the home as your principal residence for at least two years during the five year period ending on the date of the short sale, you may exclude up to $2,000,000 of debt cancellation from income. Since $40,000 is less than $2,000,000 you may not have to pay taxes on the cancellation of debt.
While in negotiations, if your lender says they will issue a form 1099-C, you should seek the advice of a qualified tax professional. More information can also be found in the IRS website about cancellation of debt income here.
