When you can't afford your mortgage, a short sale gives you a way out while avoiding a foreclosure. In a short sale, you put your house on the market until someone makes an offer your lender is willing to accept. Your lender then sells the home to a new buyer, and you avoid the foreclosure process. In Arizona or anywhere else, that may not be the end of your financial challenges, though.
Just because the bank agrees to accept a sale for less than what you originally owed, that doesn't guarantee you're free from the bank. Suppose you owe $180,000 on the mortgage and sell for $140,000. Under Arizona law, your bank can sue you for the remaining $40,000. To prevent this, you have to get a statement from the bank in writing that the sale price wipes out all of your debt and settles the mortgage. If you're in doubt what the agreement says, get legal help.
If the lender agrees to cancel your remaining debt and you owe at least $600, you and the IRS each get a 1099-C form in the mail. Forgiven debts are typically considered taxable income. If your bank forgives, say, $40,000 in debt, the 1099-C tells the IRS you have $40,000 in extra income to report. Even if the debt is under $600, it's still taxable income. You have to report it, even when you don't get a form.
If the 1099-C is for a short sale of your personal home, you may not have to worry about taxes. The 2007 Mortgage Forgiveness Debt Relief Act says you don't owe tax on cancelled mortgage debt if it's under $2 million and the mortgage was on your primary home. If you're married and filing separately, the limit is $1 million. You still have to report the forgiven debt to the IRS, using Form 982. At time of publication, the act was set to expire at the end of 2013.
If you don't qualify for the act's protection, you may still be able to avoid tax on the 1099-C amount. One method is to show that at the time you closed on the short sale, you were also insolvent, meaning that you owed more on the mortgage and your other debts than your net worth. You can also avoid tax if you file bankruptcy before the sale closes.
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