A “short sale” can be described in the most simple terms as when a lender accepts less than a borrower owes on a given property and therefore the funds received are “short” of the payoff. The amount of forgiven debt is considered to be taxable income to the borrower receiving this gift.
In 2007, as the housing crisis was getting underway, Congress passed the Mortgage Forgiveness Debt Relief Act. This act allows homeowners to avoid this tax liability on debt that was incurred by the purchase of a principal residence. In other words, if the property is your principal residence, then you will not face income tax liability on the forgiven debt.
Fast forward to 2012 and you will find that this piece of legislation is expiring at the end of this year. At the same time the Federal Government is facing a “financial cliff” with the entire world watching how we respond.
If this legislation is not extended into 2013, then home owners who are participating in these short sales will face a tax liability at the end of the transaction. For example, if a short sale was approved by the lender, forgiving $50,000 of the debt, then the mortgage holder would receive a 1099 for this amount and be subject to Federal income taxes.
If this amount becomes taxable, would mortgage holders be inclined to participate in short sales or would they more likely opt for a foreclosure if they were unable to bring the necessary funds to closing? If this legislation is not extended, will we see more foreclosures in 2013 vs. short sales? This is a question that no one has a clear answer to.