First, a short sale or foreclosure is just like any other sale as far as the tax laws are concerned. It’s entirely possible to be upside down on your mortgage AND have a taxable sale when the dust settles! This is quite common when the taxpayer has owned the home for many years and has paid off the original mortgage and then cashes out their equity with a huge mortgage to go on a buying spree. Whatever it sells for, either via a short sale or foreclosure auction, is the sales price and whatever you paid for it originally plus any improvements is your basis. The difference is the gain. The amount of the mortgage is irrelevant at this stage. If you have a taxable gain, you WILL have to pay the capital gains tax on that! There is NO way around that and the act that Congress handed off to the White House this week will NOT help you there.

Now, as to the mortgage and any Cancellation of Debt (COD) income. If the lender either allows a short sale or it goes into foreclosure for less than the outstanding balance of the mortgage AND the lender forgives the remaining debt AND the mortgage is a recourse mortgage THEN you will have COD income. That may or may not be taxable, depending upon how the numbers work out.

(The new law MIGHT help you here but many taxpayers avoided taxation on COD income under the old rules so I’ll only address them.)

If you are insolvent at the time of the COD you do NOT have to pay any tax on the amount that you are insolvent. Filing bankruptcy is one way to establish insolvency but it is not the only way. You are considered insolvent if, at the moment of the COD, the value of your assets are less than the amount of your debts. For example, if your assets totalled $80k and you owed a total of $100k, you’d be insolvent to the tune of $20k. If the COD was $20k or less, you would owe NO tax. This provision kept many taxpayers out of the IRS way under the old rules.

If you are insolvent, you file Form 982 along with a statement of your assets and liabilities with your tax return to avoid the tax on the COD up to the amount of your insolvency. This can get tricky so I would advise that if you go that route you seek the assistance of a qualified expert. Don’t trust that to the storefront tax prep mills. Too much is at stake here to risk having some part-timer earning $8 – $10 an hour get it wrong.

2. When the property is foreclosed, the bank will issue you a 1099-A. This is considered tantamount to a sale, so you will report it on your tax return (if this was your home and you have a loss, it is not deductible).

3. If the bank is unable to sell your home for the amount you owe, the bank will eventually issue you a 1099-C for the cancelled debt. *IF* your loan was a recourse loan, then the amount of cancelled debt is income to you in the year you receive the form. If the loan was non-recourse (look at your loan papers), then it’s not income to you.