Q: We bought our home for $179,000 and because of health issues, we sold our home through a short sale for $134,000.

When we went to file our income taxes, our accountant told us we would have to pay taxes on the $46,000 loss our mortgage company took when we sold our home.

Is this true? I called the IRS and whoever answered the phone told me we would not owe taxes on the mortgage company’s loss. But when my husband called, he was told we would owe about $13,000.

Ms. Glink, $13,000.00 is a lot of money for us to come up with! I read on the IRS website that if you owned your home for five years and you lived in it for at least two, a couple could be exempted from paying taxes on their home if did not sell for more than $500,000. It is Publication 523 that explains this.

My husband and I meet all of the tests listed in publication 523. We had to sell our home because of my mental health. Our accountant tells us our situation is not what Publication 523 states. He tells my husband we have to pay taxes on the $46,000 for the loss because it’s as if the mortgage lender gave us that money.

We need your help desperately, Ms. Glink. Tax time is upon us.

A: It’s clear to me that you’re a bit confused about IRS rules regarding profits and losses from the sale of property. In general, you and your spouse are each entitled to keep up to $250,000 in profits tax-free when you sell your home, for a total of $500,000, provided you have lived in your home as a primary residence for 2 of the past five years.

In your situation, you do not have a profit on the sale, you have a loss. Worse, you have a mortgage for a significant amount of money that you cannot repay. Your sale is “short” $46,000. The lender has wiped this off the books, which the IRS views as a gift of income.

Unfortunately for you and your spouse, you probably do owe tax on what the IRS considers to be “phantom income.”

This cash, commonly referred to as “phantom income” simply because it doesn’t exist in your pocket or bank account, is the forgiven amount of your loan. To the IRS, it’s as if you earned another $46,000 last year. So, you now owe tax on what the IRS views as earned income.

If you don’t have the $13,000 to pay off this bill, you will need to talk to the IRS to set up a repayment plan. Do this soon, because this issue won’t go away, and if you don’t address it now with the IRS, you will owe additional penalties on top of what you actually owned.

While this news is bound to be devastating for you, it doesn’t sound like you had much of a choice. The only other thing you could have done would have been to rent the property and wait for your local market to rebound enough to at least pay off your mortgage in full.

Published: Apr 18, 2007