Taxpayers often associate foreclosures with forgiven debt, but the issue arises with short sales as well. A short sale occurs when your lender gives permission to sell your home for less than the balance you owe on the mortgage. This usually happens because the property's market value has dropped in a troubled economy and you can't keep up with the mortgage payments because of personal hardship. The difference between the home's sales price and your mortgage is normally forgiven or canceled, and this can have tax consequences.
Cancellation of Debt
According to the Internal Revenue Service, canceled or forgiven debt is income to you. You accepted money from your lender to purchase your home, and if you don't have to give the money back, you're technically keeping it – even if you no longer have anything to show for it. You're therefore obligated to report the canceled debt as income on your tax return.
Mortgage Debt Relief Act
The fiscal cliff deal of January 2013 extended the Mortgage Debt Relief Act – which has been set to expire at the end of 2012 – through the end of 2013. Under the terms of this legislation, even though your cancelled debt is income to you, you won't have to pay taxes on it during this time. Some rules apply, however. The property you sold must have been your principal place of residence, and you can only exempt $1 million in canceled debt from the transaction, or $2 million if you're married and file a joint return.
If your forgiven debt is $600 or more, your lender is obligated to provide you with a 1099-C, the Cancellation of Debt form. This form shows the amount of your forgiven debt. Your lender also provides a copy of your 1099-C to the IRS.
Your Tax Return
If you don't qualify to exclude the canceled debt from your income under the terms of the Mortgage Debt Relief Act – such as if the property wasn't your principal residence – you must pay taxes on the amount of forgiven debt and report it on your Form 1040. If you do qualify to exclude the forgiven debt, you'll have to complete some additional paperwork: Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness. You can indicate on Form 982 that the canceled debt was associated with your qualified principal residence. You must then attach Form 982 to your tax return.
Your forgiven debt might be exempt from taxation even if you don't qualify under the Mortgage Debt Forgiveness Act. If you were insolvent at the time you sold your home – all your debts exceeded the total value of everything you owned – the income realized you from the short sale is not taxable. Debts discharged in bankruptcy aren’t taxable as income either.