With the tax filing deadline now passed, it's a bit late, but I wanted to give my readers a bit of information about short sales and taxes. If you sell your house via a short sale, is it true you have to pay taxes on the forgiven amount?
Frankly, it depends. Usually under the tax laws, if your debt is canceled or forgiven, it is defined as taxable income. However, Congress thought this didn't make sense: You lose a house by foreclosure (or short sale), and to add insult to injury, you have to pay tax on this phantom income? In response they created the Mortgage Forgiveness Debt Relief Act of 2007. This relief act allows the homeowner to exclude up to $2 million -- if that debt was on your principal residence.
Unfortunately, if the debt forgiven was on a second home/vacation/investment property, then you are out of luck; the amount that was forgiven (or canceled) is considered taxable income.
If your canceled debt was on a refinanced loan, the law gets a bit murky, if you used the refinance proceeds to substantially improve your house, then there is no tax to pay. But if you used those proceeds for other purposes then the cancelled debt is taxed.
The IRS has an excellent, free, publication on this topic, called "Canceled Debts, Foreclosures, Repossessions and Abandonments." It is Publication 4681, and is available on the IRS website -- http://www.irs.gov/pub/irs-pdf/p4681.pdf -- or by calling (800) 829-3676, or (800) TAX-FORM.
Since short sales are a part of the nation's market and will continue to be around for some time. It's important to know this fact. If you know someone who either has or may be considering the short sale option. Please send them this article or direct them to the IRS website for more detailed information.
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