Short Sale Results In Large Tax Bill

Added November 12, 2006 by Ilyce R. Glink

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Summary: Selling your home may seem like the solution when you're underwater on your debt, but not every lender will do a short sale. A short sale will also result in the IRS considering the amount forgiven by the lender as phantom income -- meaning you could face a huge tax bill the following year for the difference in the short sale.

Q: We need to get out from under a lot of debt including our home mortgage and home equity line of credit. What happens if we sell and don't make enough to pay off both mortgages?

A: When you owe more on your mortgage than the property is worth, you're considered by the lender to be "under water" on your debt.

If you want to sell the property, you'll have to come to the closing table with enough cash to make the lender whole, plus pay closing costs and fees. These closing costs might include a broker's commission (unless you sell by-owner), transfer taxes, title charges, among others. Closing costs, including a broker's commission, can run between 8 to 10 percent of the sales price of the home.

If you don't have any cash, and you owe more than the property is worth, you can ask the lender to do a "short sale" on the property. That means the lender will accept whatever cash you get from the sale of the property in full payment of the loan.

That might sounds like the good news you've been waiting for, but there are a couple of issues to think about: First, not every lender will do a short sale, and second, if you do a short sale, the IRS will consider the amount that the lender forgives you as phantom income.

In other words, you could face a huge tax bill the following April 15th for the amount of the loan you didn't repay.

For example, if you sell your home for $50,000 less than the mortgaged amount, and the lender agrees to accept a short sale, the IRS would consider the $50,000 not repaid as income to you, the borrower. When you're calculating next year's tax bill, you'll have to inflate your income by about $50,000, and pay tax on the money as if you've earned it. Depending on your income, that phantom $50,000 could push you into a much higher tax bracket.

Finally, the lender may not accept a short sale. In this case, you'd still owe whatever part of the debt that was not paid off by the sales proceeds.

Before you do anything, please talk to a knowledgeable real estate attorney who can walk you through your legal and financial options.

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