Income Tax Exemptions on Short Sales for Forgiven Debt After Foreclosure

Homeowners who sell their homes through a short sale are often very concerned about the tax implications of the sale. The bank, by forgiving a portion of the debt, is then responsible for reporting the forgiven amount to the IRS as income to the borrowers. At tax time, the former homeowners are responsible for including this amount in their gross income and then paying taxes on it.

Thus, there is a strong possibility that homeowners who sell their home for less than what they owe on it will have to pay thousands of dollars out of pocket in order to cover the tax bill on the short sale. They thought they were losing the home but avoiding having to make an expensive payment to the lender. In the end, though, they lose the home and still have to make a large payment to the IRS.

Homeowners, though, may be able to avoid this situation if they fall under a couple of exemptions, or the amount of debt forgiven is classified a certain way.

For instance, if the borrowers are insolvent prior to the discharge of the debt. The amount that can be excluded from their income is that amount up to the extent of their insolvency. As an example, f the borrowers have $10,000 in assets and $18,000 in liabilities, they are insolvent by $8,000. Debt can be forgiven up to $8,000 before they would have to report it as income to the IRS. But any amount over $8,000 forgiven would have to be reported and taxes would have to be paid on.

There is also an exemption for debts that are discharged through the bankruptcy process. There is no limit to this exemption from income, as homeowners can exclude an unlimited amount of discharged debt if it has gone through bankruptcy. The only stipulations are that the borrowers be under the supervision of the bankruptcy court, and the court grants the discharge of the debt.

Foreclosed homeowners may also be able to have the debt forgiven as interest and other fees, which do not count as income. Only forgiven principal would be considered forgiven debt, so if the borrowers and bank agree that the amount not collected due to the short sale consists mostly of fees and interest, there may be no income due to the sale of the property. This exclusion, however, may be affected if the borrowers took a tax deduction for interest in previous years.

There are a number of tax issues that homeowners should be aware of when they are considering whether or not to go through with a short sale. Although they may end up with a 1099-C form at the end of the year showing a large amount of forgiven debt, this does not mean that they have to pay taxes on all of that income, depending on their financial situation.

Despite some tax issues, a short sale still remains a viable solution to foreclosure. In fact, the government has even loosened some of the rules on income due to short sales, as well as providing other incentives for lenders to consider alternatives to foreclosing on a home. With more foreclosures will come more attempts to help borrowers reduce the financial burdens that come with owning or losing a home.