Will a Bank Forgive What's Owed After a Short Sale?

A successful short sale Realtor may be able to negotiate the remaining outstanding balance after the short sale occurs. However, the bank is under no obligation to forgive the debt. Depending on your financial situation they may require you to set up a payment plan for all, or a portion, of the remaining amount owed after the sale. If you are insolvent, unemployed, or you have a great Realtor negotiating on your behalf then the probability of the bank forgiving the deficiency is in your favor.

Anyone who agrees to have the debt forgiven by the bank needs to understand that their may be tax consequences associated with the transaction. The Mortgage Forgiveness Debt Relief Act of 2007 passed by Congress and in effect through 2012 generally allows taxpayers to exclude income from the discharge of debt on their principal residences. Here's an example of what the IRS considers taxable income:

You owe $200,000 on your home and sell the home for $150,000 leaving a deficiency of $50,000. If successfully negotiated and the bank forgives the $50,000 to be repaid, the IRS considers this taxable income in the year it was forgiven.

Taken directly from the IRS website, here are the most common situations where the debt is NOT consider taxable:

-Qualified principal residence indebtedness: This is the exception created by the Mortgage Debt Relief Act of 2007 and applies to most homeowners.

-Bankruptcy: Debts discharged through bankruptcy are not considered taxable income.

-Insolvency: If you are insolvent when the debt is cancelled, some or all of the cancelled debt may not be taxable to you. You are insolvent when your total debts are more than the fair market value of your total assets.

-Certain farm debts: If you incurred the debt directly in operation of a farm, more than half your income from the prior three years was from farming, and the loan was owed to a person or agency regularly engaged in lending, your cancelled debt is generally not considered taxable income.

-Non-recourse loans: A non-recourse loan is a loan for which the lender’s only remedy in case of default is to repossess the property being financed or used as collateral. That is, the lender cannot pursue you personally in case of default. Forgiveness of a non-recourse loan resulting from a foreclosure does not result in cancellation of debt income. However, it may result in other tax consequences.

For more information on the Act visit the following page on the IRS:

http://www.irs.gov/individuals/article/0,,id=179414,00.html

I always tell my clients to seek the advice of tax attorney to make certain they are fully aware of the implications.

J.D.A.